After RBI rate cut, should you reduce EMIs or shorten loan tenure?

The Reserve Bank of India (RBI) cut the benchmark repo rate by 25 basis points from 6.50 per cent to 6.25 per cent on Friday, February 7, 2025. This was the first rate cut in almost five years. Borrowers on flexible rate loans linked to the repo rate (home, auto, personal, etc.) stand to gain from the cut.

 

Gains for home loan borrowers 

The exact gain for each home loan borrower will depend on their current principal outstanding and interest rate. Let us assume that a borrower has a 20-year loan with a principal outstanding of Rs 75 lakh and their interest rate will come down from 9 per cent to 8.75 per cent. Their EMI will reduce from Rs 67,479 to Rs 66,278, a reduction of Rs 1,201. This will translate into an annual saving of Rs 14,412, assuming no further changes in interest rates for one year.

 

The pace of transmission of the rate cut will be faster in the case of home loans linked to the repo rate. “The exact date of rate cut transmission to existing borrowers will depend on the rate reset dates set by their respective lenders. Till then, they will continue to service their loan at existing rates,” says Naveen Kukreja, co-founder and chief executive officer of Paisabazaar.

 

In the case of loans linked to the marginal cost of funds-based lending rate (MCLR) or other internal benchmarks, transmission may happen with a longer lag. “This is because the bank’s cost of funds plays a major role in determining internal benchmark rates,” says Kukreja.

 

Usually, when the repo rate declines, the default consequence is that banks reduce the borrower’s tenure. “Banks may also allow borrowers the option to reduce their EMI and keep the tenure the same if they make a request,” says Deepesh Raghaw, a Securities and Exchange Board of India-registered investment advisor (Sebi RIA). 

 

Reduce tenure or EMI? 

Between reducing the tenure or getting the EMI reduced, the choice should depend on your financial situation. “If your cash flow is under pressure, get the EMI reduced. If it is not, then go for the default option of tenure reduction,” says Harsh Roongta, head of Fee-Only Investment Advisors LLP, a Sebi RIA.

 

If you reduce the EMI, your overall interest outgo will be higher because you will repay the loan over a longer period.

 

In the case of new borrowers, lenders may or may not pass on the rate cut. Even though the repo rate has come down, some may keep their home loan rate the same by increasing the spread.

 

If rates come down for new borrowers, besides enjoying lower costs, they will also become eligible for a higher loan amount.

“New borrowers must compare rates across lenders (for their credit score level). Window-shop for home loans at lower interest rates to enjoy significant savings in interest costs over the loan tenure,” says Abhishek Kumar, Sebi RIA and founder of SahajMoney.com.

 

Raghaw suggests that existing borrowers whose home loans are still linked to the MCLR shift to a loan linked to the repo rate. Borrowers should also continue to prepay at regular intervals to bring down their tenure and total interest cost faster.

 

Existing borrowers must ensure they are paying the best possible rate available in the market (for their credit score). “If you are paying more than the best rate, shift, either within the bank or outside,” says Roongta.

 

Lock-in rates 

Fixed deposit (FD) rates of banks may not go down immediately. “While the reduction in the repo rate has increased the chances of bank FD rates being cut, the lag in transmission of reduced repo rates to bank FDs would depend on the gap between credit and deposit growth rates, liquidity in the banking system, and other market factors,” says Kukreja.

 

In recent times, banks have been struggling to garner deposits, so they may think twice before reducing their FD rates. Most may wait for signals from bigger banks.

 

Depositors with investible surpluses for the short or medium term can consider booking FDs offering higher yields, especially those offered for longer tenures. “This will allow them to earn higher FD yields during a falling interest rate regime,” says Kukreja. Many private sector banks and small finance banks are still offering FD yields of 8 per cent and above.

 

Most experts believe this rate cut cycle is likely to be a shallow one. Some are of the view that there is even a possibility of an early reversal of the cycle.

 

“FD investors are advised to follow a laddering strategy by booking FDs for different tenures so that they stay nimble and adapt to changing interest rate situations,” says Kumar.

 

Savvy investors or those with advisors may consider shifting from FDs to debt mutual funds (MFs). “In debt MFs, when you make a withdrawal, you pay capital gains tax. On the balance, the tax payment gets deferred until you withdraw the full corpus—a big benefit,” says Roongta. In FDs, you pay tax on interest income each year.