Higher EMI or prepayment, how to minimize rising costs

The Reserve Bank of India (RBI) recently raised the repo rate by 50 basis points to rein in rising inflation in the country. With the latest hike, the repo rate is back to the pre-pandemic level of 5.40%. This is the third consecutive repo rate hike by India’s central bank since May – an off-cycle rate revision of 40 basis points in May, followed by a lending rate increase of 50 basis points in June. . The repo rate was raised by 140 basis points between May and August.

The repo rate is the rate at which the Reserve Bank of India lends money to banks and other financial institutions. It should be noted that variable rate retail loans sanctioned by banks after October 1, 2019 are linked to an external benchmark. For most banks, this external benchmark is the repo rate. The rise in the repo rate will drive up interest rates on home loans and personal loans linked to the repo rate. Home loans linked to the lending rate based on the marginal cost of funds (MCLR) and the base rate will also become expensive, as the cost of borrowing for banks will increase after the rise in the repo rate.

“The increase in repo rates by the RBI will in turn increase the interest rates of different products like home loans etc. This will in turn increase the burden on borrowers. Therefore, borrowers will feel a pinch in their pockets,” said Sujay Das, chief risk officer at Freo.

Loan interest rates to increase; Borrowers will feel the pinch

“Real estate and other retail loans linked to repo rates would witness the fastest transmission of policy rate hikes. Transmission would be faster for new floating rate retail loans,” said Naveen Kukreja, CEO and co-founder of Paisabazaar.

The exact timing of transmission of the key rate increase for new mortgages and other retail borrowers would depend on the rate reset dates set by banks in accordance with their guidelines. For existing variable rate loans tied to the repo rate, borrowers would be charged higher rates from their interest reset dates, Kukreja added.

Several banks including HDFC Bank, ICICI Bank, Punjab National Bank (PNB), Bank of Baroda (BoB), Canara Bank have already hiked their lending rates, following RBI’s announcement on August 5.

What should mortgage borrowers do now?

Increase EMI or loan term?

To mitigate the impact of rising interest rates, existing home loan borrowers can either equate their monthly installments (EMI) or their loan terms. “Note that opting for the increased tenure option would incur higher interest charges than the increased EMI option,” Kukreja added.

For example, you have taken out a home loan of Rs 30 lakh at 7.55% interest per annum, with a term of 25 years. The EMI stands at Rs 22,267. After the latest rate hike by the Reserve Bank of India, the revised interest will be 8.05%. At the new rate, you have to pay Rs 23,254 for EMI as your EMI will increase by Rs 987 per month. The interest charge will increase by Rs 2.95 lakh for the entire term.

Today, most banks prefer to extend the term of the loan while keeping the EMIs fixed. Thus, if the term of the loan is extended by 36 months, the interest charge will increase sharply. In the same example, if the interest rate remains at 7.55% and the prepayment term increases by 3 years, the interest charge will be increased by Rs 5.39 lakh.

Early repayment of the mortgage

To save the rising interest charges, borrowers can consider the prepayment option. “Borrowers of existing home loans with sufficient surpluses should prepay their home loans and preferably opt for the reduced tenure option to generate greater savings on interest charges,” suggested Kukreja. Regular prepayment will significantly reduce the outstanding amount of the loan.

Home Saver option is here for you

Borrowers with limited cash can opt for the home saver option. Under this facility, an overdraft is opened in the form of a current or savings account where the borrower can park his surpluses and withdraw from them according to his financial needs. The interest component of the home loan is calculated after deducting the surpluses parked in the savings/current account from the outstanding amount of the home loan.

Balance Transfer: Should You Go?

Another option could be to transfer the balance to a lender offering competitive interest rates. Simply put, eligible borrowers can switch their home loans to a bank that offers lower interest rates than their current lender. “Existing home loan borrowers who have witnessed substantial improvements in their credit profile while using their home loan should explore the possibility of saving on interest charges through the transfer of the home loan balance,” suggested Kukreja.

Remember that there are additional costs involved in the process, such as a processing fee or a penalty for transferring the loan balance from one lender to another. Thus, borrowers should calculate the pros and cons and the savings before opting for balance transfer.

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Bernadine J. Perkins