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A home loan switch may turn cheaper

Waiving the early payment penalty will work for borrowers whose loans are on a high interest rate regime.

india Updated: Dec 03, 2011 00:04 IST

At least two banks have waived the prepayment penalty on their home loans recently and other banks are expected to follow suit. "This is a brilliant initiative by the regulator," said Adhil Shetty, CEO, BankBazaar.com, a loan portal. "And since larger banks like ICICI Bank Ltd and State Bank of India have already waived prepayment charges, others are expected to follow suit. Competition will ensure that other banks too waive prepayment charges."

Without a doubt, this works if you are planning to prepay your loan; it will also work for those looking to switch to a loan that carries a lower interest rate. We tell you how it will benefit you.

The move
The Reserve Bank of India had asked banks to do away with pre-payment penalties in October. Even National Housing Board (NHB) had asked housing finance companies (HFCs) to do away with pre-payment penalties earlier in October. While all HFCs have complied with the guidelines, most banks are reluctant to do so.

A few, however, have gone ahead and done it. Effective 23 November, ICICI Bank has waived off prepayment charges on all floating rate home loans for old as well as new customers. The charges have been waived on part pre-payment as well as full prepayment. "No prepayment charge on floating rate home loan irrespective of the source of fund," as per the bank's website. The bank continues to charge a prepayment penalty of 2% of the outstanding loan amount plus applicable service tax and surcharge on fixed rate home loans.

Before ICICI Bank, State Bank of India (SBI) waived off charges on partial as well as full prepayment, irrespective of the source of the funds. SBI has waived off charges for fixed as well as floating loans.

Other banks may soon follow in their footsteps. "We will decide on the issue of prepayment charges in our next asset and liability committee meeting, which would most probably be held next week," said RK Bansal, executive director, IDBI Bank Ltd.

What works for you?
If you took a loan on a fixed rate of 8.5% in 2005-2006, you may not want to prepay the loan and would be better off investing the surplus you have in instruments that offer higher returns. But for those on a higher interest rate regime, prepayment reduces the total loan cost.

"Ideally, one's objective is to be debt-free as soon as possible," said Parag Paranjpe, Nagpur-based chartered accountant and certified financial planner. "Do take into account the tax benefit you may lose out by prepaying the loan. If you are someone who took the loan a year back at 11-12%, you should think of prepaying."

We took two cases to show how prepayment would work for you.

Case I: Prepayment
When prepayment penalty is charged: Let's say, you've availed a loan of R50 lakh for 20 years at 11.50% interest. Your current equated monthly instalment (EMI) stands at Rs53,321. Now assume you've serviced the loan for a year and the bank hikes the rate to 11.75% per annum and you decide to make one pre-payment of R50,000 every 12 months starting from the 13th month. With a prepayment penalty fee at 3.5% on the sum of all prepayments, you will save Rs16,60,473 on cost of loan, post hike and your tenor too will reduce by three years and nine months, instead of the remaining tenor of 19 years.

When prepayment penalty is not charged: In the above example, when the interest floats at 11.75% and the bank waives off the prepayment penalty, you will save Rs16,86,723 on the cost of the loan post rate hike, or Rs26,250 extra as prepayment fee.

Case II: Switching loans
When prepayment penalty is charged: Taking the same example taken in case I, assume you want to switch to a new lender offering 11.25% when your bank hikes the rate to 11.75%. Taking the prepayment penalty rate as 3.5% and the new lender's processing fee as 0.5%, you would manage to save Rs1,84,422 by switching the loan as compared with what you would have paid if you had continued with the loan at 11.75% for the remaining tenor.

When pre-payment is not charged: Taking the same example forward, if the bank does not charge a prepayment penalty, you would save as much as Rs3,56,816 by transferring your loan as compared with what you would have paid if you had continued with the loan post the rate hike for the remaining tenor. This saving takes into account a processing fee of 0.5% by the new lender. That means you save Rs1,72,394 extra.

What should you keep in mind? Prepaying a loan definitely makes sense, especially in the absence of a penalty. "Do keep the total cost of switching the loan to the new lender in mind," said Satkam Divya, business head, Rupeetalk.com, a NetAmbit Venture. "In other words, take into account the processing fees of the new lender, the rate of interest charged and the amount by which the EMI is reduced. Compare the total cost of the loan. And it's better to prepay in the initial years of the loan."

In most cases, it will work because one switches to a lower interest rate, but the processing fee could be a deterrent.

"While switching your loan, with prepayment charges gone, you will have to consider the new lenders processing fee," said Shetty. Axis Bank Ltd currently has a zero processing fee offer for balance transfer (switch) of home loan from another lender to them.

If your bank has still not stopped charging prepayment penalty, don't lose heart. It's only a matter of time.