Derivatives in action
Raj and Simran, a young couple, are married for three years. Raj, aged 29, is a programmer for an internet based company and Simran, aged 27, works in a financial BPO. They have no children. Raj and Simran are renting an apartment and facing a decision about whether to renew their lease. They have discussed trying to buy a house. Interest rates are attractive right now, but they wish rates were a little lower. Nonetheless, they choose not to continue renting and to start searching for a home, they can call their ‘own’. Raj and Simran then find their home and make an offer of INR 50,00,000/- (Fifty lakhs Only). With that offer, they are required to pay a sum of INR 50,000/- as a token which is valid for one month from today.
If the couple would renege, they lose the money. If not it is applied towards the purchase of their home. The seller accepts their offer. Raj and Simran have, thus entered into a contract to purchase their home at a specific closing date at a price they agree on today.
Now they apply for a mortgage. They will be required to put INR 50,000/- right now on the table and borrow the remaining amount. The mortgage lender says they can borrow at a fixed rate of 10.5% or a floating rate 9.5%. If they take the floating-rate loan, their rate will be set at 2% over the rate on a two years bank rate. The rate will be adjusted every year, will not go up more than 2 % in a year, and has a life time cap of 13%. Raj and Simran wonder which type of loan will be better and whether, inspite of the cap features, they can handle the potentially higher interest payments.
They elect to go with the fixed-rate loan. The closing date on the house is one month from now. The bank guarantees the fixed rate but also tells them that if they are willing to pay an extra sum of INR 5, 000/-, then they can have the fixed rate that is in effect on the closing date, if that rate is lower. If that rate is higher they can have the original fixed rate. Cash is tight so they elect to take the original fixed rate and not to pay INR 5,000/- for the opportunity to get a lower fixed rate.
The mortgage that they take offers the features that they can repay it at any time without any penalty. Raj and Simran realize that this feature is quite valuable, for their parents both refinanced their homes when interest rate fell.