Prepay part of your home loan to soften blow of rising interest rates

On the sunny side, FD rate hike is good news for seniors; Go for short-term deposits, roll over to those with higher rates when they mature

The State Bank of India (SBI) raised its fixed deposit rates by 10-50 basis points recently, a move that could prompt other banks to follow suit. This announcement was soon followed by several banks like SBI, ICICI Bank and Punjab National Bank raising their marginal cost of funds-based lending rate (MCLR) by 10-20 basis points. These events mark a decisive turn in the interest-rate cycle. Both fixed-income investors and borrowers need to adapt to this change in interest-rate environment.       

According to experts, banks have been forced to raise deposit rates because liquidity within the banking system has tightened. Inflationary pressures, the government exceeding its fiscal deficit target, and the US Fed signaling four rate hikes in 2018 are factors responsible for the rise in interest rates. Traditionally, the demand for funds rises towards the end of the financial year, leading to tightening. Bond yields have risen already. The 10-year government bond, a key benchmark for interest rates within the economy, is currently at 7.74 per cent, up 133 basis points from its low of 6.41 per cent on July 24, 2017. Money is going into higher-yield debt instruments and also into equity mutual funds. These factors have forced banks to raise rates to be able to garner more deposits.

The increase in fixed deposit rates is good news for retirees and other conservative investors who depend heavily on fixed deposits. But as Mumbai-based financial planner Arnav Pandya says: "Interest rates on fixed deposits are still not attractive enough." According to him, there are other options available that can offer investors better returns, such as 7.75 per cent Government of India Bonds, tax-free bonds available in the secondary markets, long-term bonds from NBFCs having tenure of three to seven years (that can offer 7.5-8 per cent), and debt mutual funds. If at all you invest in fixed deposits, go for a tenure of six to nine months. When these deposits mature, you can roll over into new ones offering higher rates, assuming that interest rates continue to surge. If you are investing in debt funds, a larger part (70-80 per cent) of your money should be in shorter-term debt funds, while the balance should go into dynamic bond funds, where the fund manager will take care of the duration risk. Keep a limited portion of your fixed-income portfolio in fixed deposits (for easy access to the money).

SBI rates for higher FD tenures upped by 50 bps
	Non-senior citizens		Senior citizens
Tenure	Old rate (%)	New rate (%)	Old rate (%)	New rate (%)
7-45 days	5.25	5.75	5.75	6.25
46-179 days	6.25	6.25	6.75	6.75
180-210 days	6.25	6.35	6.75	6.85
211 days to < 1 year	6.25	6.40	6.75	6.90
1 year	6.25	6.40	6.75	6.90
> 1 year to 455 days	6.25	6.40	6.75	6.90
456 days to < 2 years	6.25	6.40	6.75	6.90
2 years to < 3 years	6.00	6.50	6.50	7.00
3 years to < 5 years	6.00	6.50	6.50	7.00
5 years and up to 10 years	6.00	6.50	6.50	7.00
Source: SBI web site

With banks hiking their MCLR rates by 10-20 basis points, the benchmark that determines home loan rates, new customers will have to pay a higher rate of interest right away. Older customers will not be affected immediately by this change. Home loan rates of most banks are linked either to the six-month or one-year MCLR. The new rates will kick in for old customers only when the reset date arrives.

Nonetheless, if interest rates stay elevated, borrowers will have to pay more on their home loans. Here is how you can cope with rising rates. First, ensure that your loan is linked to the MCLR and not to the base rate. Also make sure that you are paying the best rates being offered in the market. If the difference is considerable, ask your bank to allow you to move to its best rate by paying a fee, or switch to another bank.

Second, whenever you get a windfall, such as a bonus, consider part prepayment of the principal. If you are on a flexible-rate home loan, you will not be charged any prepayment fee. "Before you prepay, compare the rate of return you are able to earn on your investments, given your risk profile, tenure, etc. If it is lower than the interest rate you are paying on the home loan, prepaying makes sense," says Pandya.

Normally, when interest rates move up, banks keep the equated monthly instalment (EMI) constant but hike the loan tenure. Many people think they should hike the EMI while keeping the tenure constant, to reduce their total interest cost. Pandya doesn't favour this strategy. "It will cause unnecessary disruptions. A home loan is a long-term liability. Over a 20-year period interest rates will move up and down and things will even out," he says.