Refinance to lower rate but keep up higher EMI to become debt-free faster

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Banks have been luring homebuyers this festive season with reduced home loan interests, waiver of processing fees and  loan prepayment charges.

For instance, State Bank of India (SBI) is offering an attractive discount of up to 65 basis points (bps) on home loan interest rates during its unique festive campaign offer. Regular home loan interest rates start from 9.15% per annum at the public sector lender. However, during the ongoing festive offers, the bank is offering home loans starting at the interest rate of 8.4% per annum. It has also waived 50 per cent of waiving charges. 

Similarly, HDFC Bank announced a special interest rate for home loans under its Festive Treats 2023. While standard interest rates of home loans start from 8.75% per annum at the private sector lender, it is currently offering home loans starting from an interest rate of 8.35% per annum, the cheapest among the major banks. Further, you can get  50% off on processing fees till November 20, 2023.

If you do opt for a home loan, you have the flexibility to devise a pre-payment strategy to expedite your loan repayment, adhering to your lender's minimum repayment threshold. Utilizing surplus income, such as a Diwali bonus or additional funds, is a strategic approach to mitigate your loan burden.

A solitary pre-payment can yield substantial benefits. For instance, if you borrowed Rs. 50 lakh at 7 percent interest for 20 years, your total interest would amount to Rs. 43.03 lakh, with a monthly EMI of Rs. 38,765. Initiating a pre-payment at the loan's outset would truncate the tenure by three months and slash the interest outlay by Rs. 1.15 lakh.

"Homeownership is perhaps the biggest expense you may likely bear in your lifetime. But to truly achieve Serenity, it is important that you get out of debt, and fast. There are two ways you can do that," says Adhil Shetty, CEO of Bankbazaar. 

The 5 Percent Method

First is the 5 Percent Method, a systematic pre-payment plan that lets you maximise the impact of pre-payment at optimal prepayment costs, while also helping you get out of debt. Shetty explains this with the following example: 

Loan: Rs 50 lakh at 7 per cent for 20 years. Every prepayment happens at the start of each loan year. Pre-payment amounts are theoretical; minimum payment rules apply. Simple interest and prepayment charges as applicable and not accounted for in the above calculations. Pre-payment charges vary from one loan to another

" Here you opt for annual pre-payment of 5 percent of the outstanding principal. In the case of a 20-year loan, this could reduce the loan tenure to 12 years, assuming a constant interest rate. You can opt for lump-sum prepayments once a year or prepay quarterly. This strategy typically involves pre-paying around one-third of your loan, with the rest settled through EMIs. This approach accelerates debt clearance and leaves more capital available for investment. The prepayment sum reduces annually, liberating more funds in your hands for other financial needs," said Shetty. 

Alternatively, you can increase your monthly EMIs voluntarily, thereby hastening debt liquidation. Gradually increasing your EMI in tandem with rising income is another effective method. 

Switch Hit method
Shetty says that the Switch Hit is a modern cricket shot where the batsman switches their grip from right to left or vice versa to improve their shot. " You may be surprised to know that this strategy is just as effective debt management,  which entails refinancing to a lower rate but keeping up the higher EMI to become debt-free faster." 

 The benchmark is the lowest rate at which a loan can be given. Most bank loans since October 2019 are linked to the repo rate. Loans from before that time since April 2016 are linked to the MCLR. Before that, it was the base rate. Today, repo-linked loans are the cheapest. But only banks provide them. You could refinance your loan from bank to bank, NBFC to bank, or bank to NBFC. Shetty suggests doing  a cost-benefit analysis of each option. 

Refinancing happens in two different ways. Firstly, you can ask your own lender to lower your rate. 

"You’ll need to pay a small processing fee — typically, a few thousand rupees. One of two things may happen here. One, you’ll get a lower rate if your loan is with an NBFC but your benchmark is unchanged. Or two, you may get moved to a repo loan with a lower rate, if your loan is with a bank. You can refinance even if the difference between rates is low — say, 25 basis points," explained Shetty.

The other option is to transfer 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 need to pay processing fees, legal fees, and mortgage registration fees. Shetty says a a transfer is sensible when the difference in rates is sizeable— say, 50 basis points or more — and when you’re closer to the start of your loan tenure than its end. 

When you refinance, you may have the benefit of a lower EMI. "This sounds useful and leaves you with a higher disposable income. But consider the alternative. You could keep your older, higher EMI. This helps pay off the loan faster.The higher EMIs essentially provide you with micro pre-payments, helping you bypass the requirement that the pre-payment needs to be at least one EMI’s worth. As your disposable income increases with time, you can pay higher EMIs," said Shetty.

Source: Bankbazaar