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Switching lenders: Does it make sense?

Amar Pandit  |  Mumbai 

Take a decision based on the remaining tenure, penalty and processing charges.

In the last five months, the Reserve Bank of India (RBI) announced four rate cuts, primarily to ease the liquidity crisis that has besieged the financial markets. These cuts have encouraged the public sector banks to slash rates. For instance, State Bank of India (SBI), the country's largest bank, recently froze its home loan rate for one year at 8 per cent. This is applicable for taken before April 30.

LIC Housing Finance is giving home at 8.75 per cent interest rate for less than Rs 10 lakh. There is also a 0.25 per cent discount for customers, who have investment-oriented LIC policies (unit linked insurance plans), with a sum assured of Rs 15 lakh and more. All these point to the fact that, at least in the short term, loan rates are softening.

On the other hand, many private sector players have been reluctant to cut rates, citing high cost of funds. Obviously, it means that the gap, in terms of the rates on offer, between private and public sector banks is becoming alarmingly high.

That is, many existing borrowers could be paying as much as 13-14 per cent a year. And these new rates could be a lure to switch from their existing bank.

But before you go for it, there are a number of issues that need to be looked at. For one, just because another bank is offering lower rates, it may not make sense to shift. You need to look many other factors, like prepayment and foreclosure charges. Already reports suggest that Housing Development Finance Corporation (HDFC) has hiked its foreclosure charges to 3 per cent to discourage existing borrowers from shifting.

Normally, banks and housing finance companies allow borrowers to pay around 20-25 per cent of the outstanding amount without any additional charges. However, if one wants to replay the entire amount, usually there is a prepayment penalty of 1.5 - 2.5 per cent.

Secondly, one must closely look at the processing charges of the new loan. Most institutions will charge anywhere between 0.4-1 per cent (average being 0.5 per cent) of the loan amount.

You must add these charges to the outstanding loan amount to determine the accurate equated monthly instalment (EMI). Now comes the most important part, which is the outstanding tenure of the loan. The tenure of the loan is the key in determining whether switching would make sense.

If the remaining tenure of the loan is more than 15 years, or if you have taken the loan in the last 2-3 years, even a 2 per cent discount to your existing loan will translate into a lot of savings.

In other words, if the interest rate discount is 2 per cent or more and your remaining tenure is over 14 years, you must switch the loan. At the same time, if the remaining tenure is 10-12 years, the benefits, though sizeable will not be as high.

If the remaining tenure of the loan is 7 years or less, even a 3 per cent differential might not mean a lot of savings. If the interest rate discount is 3 per cent or more and your remaining tenure is between 3-7 years, there is no pressing need to switch the loan as you would have paid most of the interest amount to the bank. Now only the principal is being deducted. In this case, calculate the exact benefits and then take a prudent call.

More importantly, remember that banks, though offering cheaper rates, have become more conservative. For instance, if you had bought a house worth Rs 50 lakh at the peak of the real estate in late 2007 with Rs 45 lakh loan, many banks may not be willing to give you that amount any more.

Banks are more likely to value the same house at 20 per cent less. And then, give 70-80 per cent of the new value. Clearly, that means that you will need to shell out a large amount from your own pocket.

Worse still, if there is more correction, the bank has the option to ask you to cough out the more money otherwise you will be put in the defaulter's list.

Besides, the technicalities and number crunching, there will be a lot of time spent on paperwork and effort, as you now have to deal with two banks.

Hence, you must make sure that the financial benefits are substantial enough to compensate you for all the effort taken.

First, check with your existing bank whether they are offering you a lower interest rate. Competitive banks, who don't want to lose a customer, will refinance your existing loan by charging a penalty and refinance fees.

In majority of the cases, this works out as the best option. The borrower does not have to once again go through the tedious process of paperwork, property valuation and disbursement. In an era when time is precious, quick execution is the most important thing.

Finally, if the numbers are in your favour, go ahead and do it NOW. Most borrowers just end up procrastinating till interest rates are on an upswing.

The writer is director, MyFinancial Advisor

First Published: Sun, March 01 2009. 00:59 IST