What borrowers can do to combat rising loan interest rates

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Home loan rates have started to rise. Experts estimate that interest rates could rise by up to 200 basis points in two years. When this happens, the term of your home loan and your interest charge will increase. However, small changes to your payment plan can ensure that your loan doesn’t drag on and that you get out of debt on time.

Here are some things you can do now to make it happen. For illustrative purposes, the example numbers we will use here are: a loan of 50 lakh at 7% for 20 years, where the EMI is 38,765 and the interest is 43.03 lakh.

Refinance your loan

First, understand your loan benchmark. Every loan has one. The reference rate is the lowest rate at which a loan can be granted. Most bank loans since October 2019 are linked to the repo rate. Loans prior to this date since April 2016 are linked to the MCLR. Before that, it was the base rate.

Non-bank financial companies (NBFC) use preferential rates. Today, repo-linked loans are the cheapest. But only banks offer them. You can refinance your loan from bank to bank, from NBFC to bank or from bank to NBFC. The choice is yours. Do a cost-benefit analysis of each option.

Refinancing is done in two different ways. First, you can ask your own lender to lower your rate. You will have to pay a small processing fee, usually a few thousand rupees. One of two things can happen here. First, you will get a lower rate if your loan is with an NBFC, but your benchmark remains unchanged. Or two, you may be transferred to a repo loan with a lower rate, if your loan is with a bank. You can refinance even if the difference between the rates is small, say 25 basis points. Refinancing the above loan at 6.75% for 20 years reduces the interest to 41.24 lakh. This therefore protects you temporarily against a rise in interest rates.

Second, refinancing can also be done by transferring your loan to another lender offering you better terms. This is called a loan balance transfer. It involves more paperwork and has higher costs. You will have to pay processing fees, legal fees and mortgage registration fees. Typically, these costs are between 0.5% and 1% of the loan. A transfer makes sense when the rate difference is significant — say, 50 basis points or more — and when you’re closer to the start of your loan term than the end of it.

Increase your NDEs

When you refinance, you can benefit from a lower EMI. It seems useful and leaves you with a higher disposable income. But consider the alternative. You can keep your older, higher EMI. This allows the loan to be repaid faster. In the above example near 50 lakh, your EMI is 38,764 at 7% and 38,108 at 6.75%. If you refinance at 6.75% but pay the original EMI (essentially, 656 more per month), it removes eight EMIs from the loan and reduces your interest to 39.57 lakh.

Higher EMIs essentially provide you with advance micropayments, helping you circumvent the requirement that the prepayment must match at least one EMI. As your disposable income increases over time, you may pay higher EMIs. In the 6.75% calculation above, assume you have chosen to increase your EMI to 50,000. This reduces your 240 month loan to 148. This also reduces your interest to 23.68 lakh. It is a powerful option.

Smart prepayments

A one-time, lump-sum prepayment erases the additional interest from rising rates. For example, if your A loan of 50 lakh for 20 years has a rate hike of 25 basis points to 7.25%, your interest increases to 44.84 lakh. It also adds 11 EMI to the loan. But an immediate bullet payout of 1 lakh clears extra EMI.

The other option is to prepay systematically. We believe that the optimal prepayment for a home loan is 5% of your loan balance once every 12 months. This method pays off a 20-year loan in about 12 years assuming a constant rate. It’s optimal. You can always go faster if you want. The idea is to use more of your savings to invest and build wealth. A combination of the above options will also help. What you must not do is not act. It would greatly increase your interest.

Worst-case scenario, if your loan goes from 7% to 9% in two years, you could be looking at over 100 additional EMIs. These could become barriers to achieving aspirations such as retirement or raising children. You wouldn’t want that.

Adhil Shetty is CEO of BankBazaar.com.

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