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Suresh Krishnamurthy

Opting for floating rate mortgages when interest rates have bottomed out, and pouring money into stocks when valuations are expensive can enhance risks substantially for the investor. Adverse interest rate movements can severely compromise financial security.

THE economy is improving. Inflows of dollars into the country are peaking. Interest rates are now at an all-time low and threatening to go down further. The future looks promising as never before.

At the same time, however, inflation is rising. It is now at 5 per cent and, according to experts, looks set to reach 6 per cent by the end of the year. Wages are also set to increase only at nominal rates each year. After the election, tax laws may be changed to enhance taxes in order to combat the burgeoning fiscal deficit.

In addition, investors now have no option but to invest in fixed rate deposits and equities, both of which seem set to offer lower returns. To this combination of low-return fixed deposits and equities, add floating-rate mortgages, and the risks seem to have piled up pretty high for investors.

Thisbecause investors are opting for fixed rate deposits and floating rate mortgages at the bottom of the interest rate cycle and investing in equities when stock prices are at their peak.

Managing these risks are, therefore, critical — not only to enhance returns which, anyway, are barely likely to be in double digits over a longer period of over 15 years. But also to ensure that negative developments do not destabilise your financial security.

Transfer of risks: As a product, mortgages are selling thick and fast. However, more than three-fourths of the mortgages sold by the three largest lending institutions — ICICI, SBI and HDFC — are floating rate mortgages. These institutions are not making it easier for the borrower.

The difference in interest rates between fixed rate mortgages and floating rate mortgages are now more than a percentage point. Investors are lured to opt for the floating rate mortgages. At the same time, investors are pouring funds into bank term deposits, which offer only fixed rates.

In other words, these institutions, which are savvy and aware of the best deals in town, are transferring interest rate risks to the retail investor on both the asset and liability sides.

On their liability side, if interest rates rise, they will not have to shell out higher interest to the investor. However, on the asset side, if interest rates rise, the equated monthly instalment on the mortgages will rise.

Over a period of 15-20 years, interest rates could move through several cycles. So, if you have taken a floating rate mortgage at the bottom of this interest rate cycle, then over a longer term, you may be forced to transfer a part of your wealth to the lending institutions. That can leave you with just the house and substantially depleted savings to take care of your retirement.

Managing risks: There are ways to manage these risks. However, the weapons in the armour of the retail investor are limited. In this context, much thought has to go into the choice of a mortgage.

Investors can opt for floating rate mortgages only when they are capable of repaying the loan over a short period of 5-7 years. At least, they should have the ability to pre-pay the loans if interest rates rise sharply. Otherwise, fixed rate mortgages appear the most suitable.

Mortgages are also exposed to another risk — change in tax laws. Tax authorities are itching to take away the benefit of interest rate deduction. In this context, it would help if payment for a mortgage does not account for a substantial portion of your monthly income.

On the investment side, floating rate mutual fund options are now quite attractive. They can benefit you if interest rates do rise. So, investing a substantial proportion of your surplus in high-return savings options of the government and in floating rate mutual funds appear sensible.

As regards equities, investing in a disciplined manner in phases over many years is now quintessential. Investing when the market is on a high, getting scared and staying away from the markets when the valuations are attractive is not an option.

Finally, how interest rates move is left to providence and the Government. If the Government pursues sensible policies, does not increase tax incidence and tempers inflationary expectations, our wealth can also rise. Benign interest rate trends over substantially longer periods will also help.

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