Home Loans Are Getting Even Costlier. Here’s How To Reduce The Burden
In less than 1 year many home loan borrowers will have seen rates go up 190 bps. A simple choice can dramatically change the cost.
Borrowers are set to pay much more on their loans with the Reserve Bank of India now having increased the policy rate by a total of 190 basis points since May this year to curb the spike in inflation. The latest hike was on Friday by 50 basis points.
A large part of this increase has been passed on to borrowers.
All new floating-rate loans, including home loans, issued after Oct. 1, 2019 are based on the repo-linked lending rate. This rate-fixing regime replaced the marginal cost of funds lending rate, as the central bank sought to increase the pace of transmission of changes in the policy rate.
The repo-linked loans have a reset of interest rate every month or quarter, while MCLR-linked loans are usually reset every year. Some banks, like State Bank of India, have reduced the reset date on the MCLR loans to six months.
At the start of the year, home loan borrowers, who had benefitted significantly from the rate cuts undertaken during the pandemic, were being levied historically low rates that ranged from 6.8% to 7%. For repo-linked loans, by the end of December, all borrowers will have to pay 190 basis points more than they did at the start of this year.
Banks have two ways of transmitting higher interest rates to borrowers. Either they increase the amount that the borrower pays every month through equated monthly instalments or they increase the tenor of the loan. In most cases, banks prefer to increase the tenor of loan.
Here’s an example of how this would pan out.
In our example, an individual has a home loan with Rs 30 lakh outstanding that must be repaid in 15 years at 7%.
At 8.9%, which could well be the rate at the end of 2022, the individual would have to pay an EMI for 56 additional months or nearly five years. This results in a steep increase in interest cost—to the tune of Rs 15.1 lakh.
If the individual chooses to increase the EMI, they would have to pay Rs 3,285 more every month. In this instance, the additional interest is still significant at Rs 5.9 lakh, but substantially lower than if the tenor is increased instead.
In some scenarios the option will be taken out of the hands of the borrowers. Banks do not prefer to extend the tenor beyond a certain extent if it means that the individual would be repaying their loan beyond the age of 60.
It is important for the borrower to follow up with their lender to identify when rates are reset, according to Adhil Shetty, chief executive officer at BankBazaar. The borrower would do well to get in touch with the bank and stipulate that they would prefer to increase EMI rather than tenor, he said.
With interest costs going up substantially, Shetty said it is a great idea for borrowers to pre-pay their loans wherever possible. The best time to do this is in the first few years of the loan repayment cycle because of the way EMIs are structured. In the first half of the repayment period, the interest forms a larger component of the EMI.
A great approach to have is to pay back 5% of the loan outstanding in an additional payment to the lender every year, Shetty said.