Chapter 7: Interest Rates 203

Mortgage Modification/Balance Transfer

We are convinced by now that the interest rates are known to vary over
time. For example, review Figure 7.6 that illustrates the variation in the
PLR of the State Bank of India between 1996 and 2009. It exhibits a notice-
able change from 15.5 percent in September 1996 to 10.25 percent in
January 2004. For the sake of simplicity, let us assume that for any mort-
gagor with a particular profile and mortgage requirements the bank
determines a contract rate which is the same as the PLR at that time. Thus,
if the mortgage was underwritten in September 1996, the nominal (con-
tract) rate was determined at 15.5 percent. However, had the same mort-
gage been issued in January 2004, the rate would have been 10.25 percent
instead.
From our previous discussions, it is evident that these changes will
have considerable effect on the mortgage debt service. Now consider
Sukhbir, a mortgagor who gets a mortgage loan issued in September 1996
at 15.5 percent. He keeps paying the stipulated debt service. However, the
PLR of the bank kept falling since then. In May 1999, Meera, his neighbor
gets a mortgage loan approved at a rate of 12 percent. This is 350 percent

Figure 7.6 Variations in PLR (State Bank of India)

16
15.5% | Sep 1996
Prime Lending Rate in %

15
14.5 % | Nov
1996
14 13.75% Aug 2008

13

12 12% | May 1999

11.75% | Jun
11 11% | Apr 2002 2009

10 10.25% | Jan 2004

Data Source: Reuters, India.

204 Real Estate Finance in India

points lower than Sukhbir’s, although the mortgage principal and term
are the same as Sukhbir’s. Thus, for the same mortgage, Sukhbir ends up
paying higher cost than Meera. Would Sukhbir be locked in with his cur-
rent cost throughout the life of the mortgage?
In the case of home loans, balance transfer is a mechanism through
which a mortgagor may transfer the outstanding balance from one mort-
gage contract to another. Usually, the balance transfer takes place when
two different lenders are involved. Loan modification refers to changing
some elements of an existing mortgage contract with the same lender.
Balance transfer and loan modification are sometimes used synony-
mously in Indian home loans. They are more popularly known as refi-
nancing in the U.S. However, this should not be confused by what is
referred to as refinancing in the context of Indian monetary system which
we discuss in greater detail in another chapter (Chapter 9; see Secondary
Mortgage Market). It is easy to conclude that a mortgagor will opt for a
balance transfer or a loan modification when the interest rates fall in the
market. However, what could be the motivation for the lenders? By offer-
ing the loan modification, a bank tries to reduce the chances of default or
prepayment. Through balance transfer, the new bank may earn new
business.

Scenario II: Loan Modification Analysis

You want to modify a mortgage loan which you took six years ago
worth `300,000 on a monthly amortizing, 25-year fixed rate mortgage
with a contract rate of 7 percent. The new contract rate is 6 percent. Your
bank says that the loan modification requires paying 1.5 points and
3 percent closing costs. Assume that you want to serve the complete term
of the loan.
Questions you should try to answer:

1. Should you go for the modification?

2. By modifying, you want to receive the saved money up front.
How much would be your savings?
3. By modifying, you want to reduce your payment amount. How
much do you save every month?
4. By modifying, you want to reduce the number of repayments.
How many more payments would you make?
5. Now assume you only want to live in the house for next five
years. Would modifying be a good idea?
 Chapter 7: Interest Rates 205

Synposis
We learned earlier in this chapter that interest rates vary over time and as
a mortgagor you may want to benefit from an environment of lower inter-
est rates, especially if your existing mortgage contract is based on a higher
rate. That is exactly what the scenario just mentioned is about. Let us find
the answers to each question one-by-one.12 To solve these problems, you
can apply various mathematical formulas for annuities. You could also do
the same calculations using Excel or your financial calculator. It will be
clearer from the following discussions.

1. Should You Go for Refinancing?

How will you decide whether the new loan contract is worth the modifi-
cation or not? The criterion is simple: your effective cost of the debt must
be lower compared to the existing loan. It is likely that the contract rate
on the new loan is lower than the earlier loan. However, it may not defini-
tively be concluded from this information that the effective rate will be
lower too. In fact, there may be additional costs involved in the balance
transfer that need to be taken into account. Which may substantially
change the cost of borrowing? We discussed this topic in detail in
Chapter 4 (see Effective Borrowing Cost).
Before considering the new loan, let us understand the existing loan.

The existing loan:

I = 7% / 12, PV = 300,000, N = 25 x 12, FV = 0
Therefore, you can easily calculate the monthly payment:
PMT = –2,120.34

To calculate the balance at the end of sixth year, you could use either
the Excel, the calculator,13 or the mathematical formulas in one of the fol-
lowing calculations (both lead to the same loan balance).

12
You should be careful about the number of payments per year (m). In most
typical cases, m is 12 implying monthly amortization. Therefore, you could
simply arrive at your calculations by dividing the annual interest rate by m (I / m)
and multiplying the loan term by m (N × m).
13
You may also utilize the 2ND [AMORT] feature of the calculator. To calculate
the balance using the calculator: AMORT → P1 = 1 → P2 = 12 × 6 → Balance.
206 Real Estate Finance in India

(a) Present value of all the remaining,14 i.e., PV when PMT =

–2,120.34, N = (25 – 6) x 12, FV = 0, I = 7% / 12
(b) Future value of the payments already made, i.e., FV when PMT =
–2,120.34, N = 6 x 12, PV = 300,000

Effective borrowing cost

Points = 1.5% × 266,980.16 = 4,004.70
Closing costs = 3% × 266,980.16 = 8,009.4
Therefore, new principal = 266,980.16 + 4,004.70 + 8,009.4 = 276,676.49

The Breakeven Rate

Note that in most cases the borrower does not make any cash payment
towards the loan modification cost. The bank may make these payments
and add them to the loan balance. The sum acts as the principal for the
new loan. Now, suppose that in theory the bank pays for all these costs,
but nothing changes at the your (borrower’s) end (i.e., you keep making
the payments as originally scheduled). In this case, the effective rate of the
loan will be smaller than the original contract rate simply because the
bank paid some additional cash at the time of refinancing but did not
expect any additional payments from the borrower. This effective rate is
called the breakeven rate. However, the borrower is not benefitting from
the breakeven rate, and is indifferent about refinancing at this rate.
DECISION RULE: The borrower will refinance only if the effective
rate on the new loan is lower than the breakeven rate.
This is how we calculate the breakeven rate for the remaining of the
loan:

PV = 278,994.26, N = (25 – 6) x 12 = 228, PMT = –2,120.34, FV = 0

→ I = 6.42% (annually)
Breakeven rate = 6.42%

Since the new contract rate (6 percent) is smaller than the breakeven
rate (6.42 percent), refinancing is a good idea.

2. How Much Money Can You Earn Up Front by the Modification?

Now that we have analyzed that the modification is a good option for
you, we also need to know how good it is. There are many ways in which

14
Remaining payments will exclude the first six years from the overall 25
years, times 12 months per year.
 Chapter 7: Interest Rates 207

as a borrower, you may want to benefit from the modification. For exam-
ple, you may ask the bank to make you some up front payment that
comes from the savings due to the modification. However, you will keep
making the payments in future as you had been making so far. How
much money will that be? Here is how to calculate that:

Original loan balance = 278,994.26

New loan:
I = 6%, FV = 0, N = 228, PMT= –2,120.34
→ PV = 288,057.19
Therefore, cash out = 288,057.19 – 278,994.26 = 9,062.93

3. How Much Money Can You Save in Payments by the Modification?

Suppose that instead of collecting the savings up front, you want to dis-
tribute it over all the future payments. In other words, you would rather
like to reduce your future payment amounts. How much can you reduce
your payment?

New loan:
I = 6% / 12, FV = 0, N = 228, PV = 278,994.26
→ PMT = –2,053.63
Monthly saving = 2,120.34 – 2,053.63 = 66.71

4. How Many Payments Can You Reduce by the Modification?

Suppose that instead of saving the cash up front or saving on the monthly
payments originally scheduled, you would like to reduce the number of
payments. How many remaining payments would your contract be
left with?

I = 6% / 12, FV = 0, PV = 278,994.26, PMT = –2,120.34

→ 215.07

Therefore, remaining payments = 216 months.15

15
Note that the number calculated is not a whole number. If you round it down
(to 215) then the final payment (216th which will be smaller than the current
payment) must be included in the 215th payment. This will not only increase the
payment amount, but may also trigger some prepayment penalty, although very
small.
208 Real Estate Finance in India

5. Modification Followed by Prepayment

It is not unlikely that for some reason you would like to prepay your
modified loan. The prepayment may incur some penalty, if the new con-
tract specifies so. However, in this example, there is no prepayment pen-
alty. As we saw in Chapter 4, that despite no prepayment penalty, the
modification cost may substantially increase the effective cost if the loan
is prepaid. Here is how we analyze the scenario:

Original loan:
PV = 300,000, I = 7% / 12, N =25 x 12, FV = 0
→ PMT = –2,120.34

Now, we need to calculate the balance of the original loan (pretending as

if nothing has changed at the borrower’s end); i.e., at the end of 6 + 5 = 11
years.
We can calculate the balance as 226,676.49.

New loan
PV = 278,994.26, FV = –226,676.49, N = 5 x 12, PMT = –2,120.34
→ Breakeven (annual) rate = 5.89%

The cost of the new loan (6 percent) is higher than the breakeven rate.
Therefore, refinancing is NOT a profitable proposition in this particular
case.

Scenario III: A Balance Transfer Analysis

In September 2008, the Gruha Fund Bank issued a mortgage principal of
`15 lacs to Sukhbir for a 20-year term at 15.5 percent nominal rate. By
September 2011 the interest rates falls considerably. Sukhbir finds out that
Ashiana Finance, a competitor bank, is willing to offer an interest rate of
11.75 percent if Sukhbir transfers his mortgage balance to them. However,
Sukhbir would have to pay an additional mortgage underwriting costs
worth 5 percent of the new principal and `12,000 towards professional
charges. When Sukhbir discusses this with Gruha-Fund, they remind him
of the prepayment penalty of 3 percent of the remaining balance as per
the original contract. Is this balance transfer to Ashiana-Finance any good
for Sukhbir?

Gruha Fund mortgage contract:

Principal, in ` (PV) = 1,500,000
 Chapter 7: Interest Rates 209

Term, in years (N) = 20

No. of payments per year (m) = 12
Contract rate (R) = 15.5%
R 15.5%
PV * 1, 500 , 000 *
PMT = m = 12 = 20 , 308.21
   
 1   1 
1 − N*m
 1 − 20 * 12

  R    15.5%  
  1 +     1 +  
 m   12 

Therefore, so far, Sukhbir has been making a monthly payment of

`20,308.21.

Loan balance in September 2011 (three years later):

Remaining number of payments (n) = total number of payments –
number of payments already made
= 20 x 12 – 3 x 12 = 204
   
PMT  1  20 , 308.21  1 
PV = 1 − = 1 −  = 1, 457 , 569.80
r   n
r  15.5%   15.5%   204

1+     1 + 12  
m   m  12  
 hus, at the end of three years, Sukhbir owes a sum of `1,457,569.80
T
to the bank.
Prepayment penalty = 3% of `1,457,569.80 = `43,727.09
Sukhbir does not pay the penalty in cash. Rather, he adds this amount
to the principal of the new mortgage to be issued by the bank.
Therefore, pay off of existing loan
= remaining balance + prepayment penalty
= `1,457,569.80 + `43,727.09
= `1,501,296.89; this is the amount of balance transfer.

It is not surprising to find in such a scenario that even after three

years of payments, the mortgage pay off is higher than the original mort-
gage principal of `15 lacs.

Ashiana Finance mortgage contract:

Principal, in ` (PV) = 1,501,296.89
Refinancing cost
210 Real Estate Finance in India

= Administrative fees + Professional charges

= 5% of `1,501,296.89 + `12,000 = `87,064.84
No. of remaining payments**16 (n) = 12 x (20 – 3) = 204
Contract rate (R) = 11.5%
R 11.5%
PV * 1, 501, 296.89 *
PMT = m = 12 = 16 , 785.94
   
 1   1 
1 − n
 1 − 204

  R     11.5%  
  1 + m     1 + 12  
   
Saving in the monthly payment
= Original monthly payment – New monthly payment
= `20,308.21 – `16,785.94 = `3,522.27
Now, we need to calculate the NPV of these savings at a discount rate
of 11.5 percent.
   
Saving  1  3 , 522.27  1 
NPV = 1 − = 1 −  = 315 , 023.85
r   n
r  11.5%   11.5%   204

1+     1 + 12  
m   m  12  

The NPV of the savings made by the balance transfer (i.e., `315,023.85)
is substantially higher than the cost of refinancing (i.e., `87,064.84).
Therefore, yes, Sukhbir should accept the offer from Ashiana Finance.

Glossary
Opportunity Cost: The return on best alternate investment of the money.
Weighted Average Cost of Capital: The weighted mean of cost of equity
and cost of the debt capital.
Monetary Policy: Changes in interest rates and money supply controlled
by the RBI.
Fiscal Policy: Changes in the taxing and spending controlled by the cen-
tral government.
Treasury Bills: Short-term debt securities backed by the government.
Treasury Bonds: Long-term debt securities backed by the government.

16
** Note that it is not necessary that the new (transferred) loan will assume the
same term (i.e., 204 months) . However, with the knowledge you have so far, you
should be able to run this analysis for whatever the term of the new loan is.
 Chapter 7: Interest Rates 211

Benchmark Prime Lending Rate (BPLR): Determined on the basis of cost

of funds, operational expenses, minimum margin to cover regulatory
requirements of provisioning and capital charge, and profit margin.
Base Rate: Determined on the basis of cost of deposits, cost of maintain-
ing the statutory liquidity ratio and cash reserve ratio, cost of running
the bank, and profit margin.
Bank Rate: Interest rate at which the RBI buys commercial papers from
commercial banks.
Repo Rate: Interest rate at which banks may borrow money from the RBI
for short-term (as short as one day).
Reverse Repo Rate: Interest rate at which the RBI may borrow money
from commercial banks for short-term (as short as one day).
Cash Reserve Ratio: The percentage of total cash that a commercial bank
has to maintain as a balance with the RBI.
Mortgage Modification/Balance Transfer: A mechanism through which
a mortgagor may transfer the outstanding balance in a mortgage con-
tract to another mortgage contract.

End-of-Chapter Questions
1. What is loanable funds theory? Explain the interest inelastic character-
istic of a government’s demand of funds.
2. Explain how the RBI controls the monetary policy.
3. How does the supply of loanable funds effect the interest rate? Explain
the theory of liquidity effect, income effect, and price anticipation.
4. Describe the cycle of capitalism.
5. Why was BPLR replaced by base rate?
6. How does balance transfer protect a borrower from interest risk?
7. Define following terms:
(a) WACC
(b) Fiscal borrowings
(c) Bank rate
(d) Repo rate
(e) Reverse repo rate
(f) Cash reserve ratio
(g) Open market operations
(h) Fisher equation
8. Compare and contrast:
(a) Macro versus microeconomics
(b) Monetary versus fiscal policies
212 Real Estate Finance in India

(c) Treasury bills versus treasury bonds

(d) Benchmark prime lending rate versus base rate

End-of-Chapter Practice Problems

1. Ramesh purchases a property combining his own money (50 percent)
and the bank financing (50 percent)? If the cost of equity is 15 percent
and the cost of debt capital is 12 percent, what is the discount rate
(WACC)?
2. The RBI issued a treasury bill at a discounted value of `95 which has
the face value of `100 and the maturity of 250 days. What is the yield
offered by this security?
3. Calculate the yield offered by the following zero-coupon securities.
Assume simple interest.
Face Value Discounted Value Maturity (in years)
(a) 100 93 1
(b) 500 460 1.2
(c) 200 180 1.5
(d) 100 86 2
(e) 500 400 3
4. Calculate the present value of the following 10-year government
bonds. Market interest rate is 11 percent.
Face Value Coupon Rate
(a) 1000 10%
(b) 5000 12%
(c) 2000 9%
(d) 1000 11%
(e) 5000 12%
5. Mohan wants to modify a mortgage loan which he took 6 years ago.
The original loan principal was `250,000 on a monthly amortizing, 25
year fixed rate mortgage with a contract rate of 7 percent. The new
contract rate is 6 percent. His bank says that the loan modification
requires paying 3 points and 1.5 percent closing costs. Assume that
Mohan wants to serve the complete term of the loan.
(a) Should he go for the modification?
(b) By modifying, he wants to receive the saved money up front. How
much would be his savings?
(c) By modifying, he wants to reduce his payment amount. How
much does he save every month?
 Chapter 7: Interest Rates 213

(d) By modifying, he wants to reduce the number of repayments. How

many more payments would he make?
(e) Now assume he only wants to live in the house for next 5 years.
Would modifying be a good idea?
6. State Bank of India (SBI) issued a `2,500,000 loan to Sanjay for a 30-year
term and 15.5 percent nominal rate. After 3 years Sanjay finds out that
Punjab National Bank (PNB) is willing to offer an interest rate of 11.5
percent. In order to balance transfer Sanjay will have to pay a prepay-
ment penalty of 3 percent of the remaining balance to the SBI, under-
writing cost at 5 percent of the new loan principal and Rs15,000
towards professional charges to PNB. Should he go for the balance
transfer?

References and Suggested Readings

Ahluwalia, M. 2002. “Economic Reforms in India Since 1991: Has Gradualism
Worked.” Journal of Economic Perspectives, 16(7): 67–88.
Ben-Shahar, D., Leung, C., and Ong, S.E. 2008. Mortgage Markets Worldwide.
Oxford: Wiley-Blackwell.
Finance, I.I. 2010. Financial Management. Chennai: Macmillan Publishers.
ICRA. 2011. MBS Pool Rated by ICRA: Report on Performance until March 2011.
Kolkata: ICRA.
Miller, M. 2002. “Political Economy of Directed Credit.” CCS Working Paper.
New Delhi: Centre for Civil Society.
NHB. (n.d.). Role of National Housing Bank. Retrieved from NHB.org.in: http://
www.nhb.org.in/Financial/role_of_nhb.PHP, retrieved on 1 October 2012.
Pandey, I. 2010. Financial Management. New Delhi: UBS Publishers.
Shah, A., Thomas, S., and Michael, G. 2008. India’s Financial Markets: An Insider’s
Guide to How the Markets Work. Aurora, IL: Elsevier.
Sivam, A., Evans, D., King, R., and Young, D. 2001. “An Approach to Improved
Housing Delivery in Large Cities of Less Developed Countries.” Habitat
International, 25(1): 99–113.
Sridhar, V. 2002. “Securitization in India—Opportunities and Obstacles: A
Discussion Paper.” IIM Calcutta. Kolkata.