How Mortgage loans work?

By: Bank of Baroda
Fri Nov 1, 2019
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Home loan or Mortgage loans is without a doubt the longest loan a person takes in his lifetime. Most other loans like personal, education and automobile loans are of shorter duration but a home loan can last for as high as 30 years. It is thus very important to understand all aspects of this loan.

Whenever one buys a home, the lender will use the home as collateral against a possible default in the future. The term Mortgage means passing the Charge on the property to the lender as a security.

Home is one of the few assets whose price does not fluctuate as much as of other financial assets. In fact, in a growing economy, the price of the home moves higher gradually every year. Hence, in this case, banks are relatively assured of recovering their money in case of a default. In most cases, banks do not ask for any other security when they disburse Mortgage loans.

There are various components of a Mortgage loan. First, the maximum amount of loan that a lender disburses is restricted by regulators. Some lenders consider the taxes, statutory charges, and insurance under the total value on which loan can be available. A borrower will thus have to clarify with the lender on the total amount that will be considered for calculating the loan value.

The amount that the bank will disburse will be the amount on which it will be charging interest. The consumer will have to repay the loan amount plus the interest that is charged over the years.

The interest that is charged on the loan is floating. This interest is normally calculated on a reducing balance basis. In the initial years, the lender would take more as interest and less of capital from the equated monthly installments (EMI) as the loan amount outstanding is almost full in the initial years of loan.

Consider a person has taken a loan of Rs 50 lakh from a bank for a period of 25 years. His EMI would work out to be Rs 41,000. When this Rs 41,000 is deducted from the borrower on a monthly basis, in the initial years less than 10 percent of the amount is deducted from the –Principal of Rs 50 lakh. A major chunk of the interest that a borrower pays on his loan is deducted in the first half of the tenure.

It is thus advisable to repay part of the mortgage loan or foreclose it in the first half of the loan tenure if one can afford the same.

Every month the interest is charged on the reduced Principal that is left over from the previous month. In banking terms, the remaining Principal is called the outstanding loan amount.

In India, there are no charges applicable for foreclosing a home loan. In other loans pre-closing a loan carries a charge.

At the time of availing the loan lenders generally give an amortization sheet which clearly mentions the interest and principal that will be deducted every month for the entire tenure of the loan.

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