Cut home loan costs: Retain EMI, shorten tenure, consider prepaying

Borrowers can maximise savings when interest rates fall by retaining their EMI and reducing tenure, while also benefiting from repo-linked loans and selective prepayments

The Reserve Bank of India (RBI) has cut the repo rate by 50 basis points to 5.5 per cent. Since February, the repo rate has fallen by 100 basis points. Interest rates on new home loans, already below 8 per cent following the April cut, will decline further.

 

The latest repo rate reduction will lower EMIs on home loans. For instance, on a ₹75 lakh loan for 20 years with an initial rate of 8.5 per cent before the February cut, the EMI would have been ₹65,087. Once the latest cut is passed on, the interest rate will drop to 7.5 per cent and the EMI to ₹60,420—a decrease of ₹5,387.

 

Quicker gains for repo-linked borrowers

 

The pace and quantum of transmission depend on the benchmark used by the lender and the reset dates for borrowers. “The transmission will be quickest and absolute in the case of existing home loans linked to the repo rate,” says Santosh Agarwal, Chief Executive Officer (CEO), Paisabazaar.

 

The RBI mandates that interest rates of repo rate and other external benchmark-linked home loans be reset at least once every three months. 

“In recent times, public-sector banks have been faster in passing on benefits to borrowers than private banks,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi) registered investment adviser and founder, SahajMoney.com. 

 

Impact on new borrowers

 

Whether new borrowers benefit to the same extent as existing ones depends on the spread or credit risk premium. “If banks continue with the same spread, the quantum of rate reduction for new home loan borrowers will be the same as for existing borrowers,” says Agarwal.

 

Sometimes, when credit demand is high, banks increase their spread over the repo rate, which reduces the benefit for new borrowers. “Some banks might also take time to adjust their pricing for new loans based on their net interest margin (NIM) projection,” says Kumar.

 

Lower rates do not just allow new borrowers to pay a lower EMI. “They also increase loan eligibility,” says Kumar.

 

Reduce tenure or EMI?

 

When rates fall, banks typically keep the EMI unchanged and reduce the tenure. “Borrowers can choose between reducing the EMI or the tenure,” says Adhil Shetty, CEO, BankBazaar.com.

 

Kumar suggests that maintaining the current EMI and reducing the tenure results in greater savings in interest cost over the long term.

 

“This decision must, however, be taken only if the borrower’s cash flows permit,” says Vishal Dhawan, Chief Financial Planner, Plan Ahead Wealth Advisors. 

 

Loans linked to older benchmarks

 

For home loans linked to internal benchmarks like the marginal cost of funds-based lending rate (MCLR) and the base rate, the transmission of rate cuts is slower. “Lenders’ cost of funds plays a major role in determining internal benchmark rates,” says Agarwal.

 

Kumar adds that for MCLR-linked loans, the reset period typically ranges from three months to one year.

 

“If you are on an older benchmark, consider a switch to a loan linked to an external benchmark,” says Shetty. Dhawan adds that those loans are more transparent.

 

Borrowers on repo-linked loans should also periodically check if they are on the best rate available in the market, particularly if their credit score has improved.

 

Consider costs before switching

 

Switching loans typically involves various costs: processing costs, documentation charges, property valuation charges, and so on. “When you compare the interest rate offered by a new lender with your existing rate, take these costs into account for a better picture of the benefit,” says Dhawan.

 

Consider prepaying

 

Existing borrowers should also consider prepaying their home loan.

“If you do this amid falling interest rates, you can reduce your overall interest liabilities significantly,” says Shetty.

 

However, weigh a few factors before prepaying. “If you can invest the money in an instrument like equity mutual funds that can give you higher post-tax returns, doing so rather than prepaying may make more sense,” says Shetty.

 

Consider your liquidity position as well. “Do not overstretch yourself or empty your emergency fund to prepay,” adds Shetty.

 

Dhawan observes that prepayment is particularly beneficial in the early stages of a loan.