Not enough reason for home loan switch
Easing home loan rates is no longer news as at least six state-run banks have reduced floating home loan rates by at least 25 basis points (bps) for new loans. With the repo rate cut earlier this year in April and a cut in cash reserve ratio in Monday’s monetary policy review, interest rates may start to go down soon.
Banks are wooing retail customers by bringing down home loan rates in anticipation of a change in the interest rate cycle and tapering of corporate lending because of slowing economic growth. Data from the Reserve Bank of India (RBI) show the credit growth from banks slowed to 16.5% currently from 20%-plus credit growth only a couple of years ago.Do lower home loan rates mean you need to reassess and switch your existing loan? If you have been waiting on the sidelines for a new loan, should you jump in? We ran some numbers and spoke to a few experts to help with that decision.
Switching existing loan Certainly, the slew of announcements on lower home loan rates is enticing enough to consider a switch, but keep in mind that a 25 bps lower rate is not enough by itself. One basis point is one-hundredth of a percentage point.
Also, be mindful that banks are not reducing base rates and are reducing interest rates for select product baskets. If base rates fall then interest rates on all products move lower, but now you have to check clearly on where the reduction applies. There are three main things you need to look at. First, the rate — how much lower is it than your current rate. Second, the tenure remaining on the loan. And lastly, the switching cost.
This is the first thing you will look at-how much lower is the rate on offer compared with your existing home loan rate? A lower rate of interest will basically lower your monthly payouts or equated monthly instalment (EMI) and your interest payment over the remainder of the loan.
A 25 bps lower rate say on an outstanding balance of Rs. 20 lakh for a period of 20 years, will result in a saving of around Rs. 337 in EMI if your original loan was at an interest rate of 10.75% per annum; the total interest payout will be lower by about Rs. 80,000.
The next thing you need to look at is the term remaining on your outstanding loan. For example, if you have taken a 20 year loan in September 2007, there are now 15 years remaining on your loan. Numbers show that lower the remaining tenure on your loan the lesser you will save by switching your loan.
Sample this: You have a 20 year Rs. 45 lakh loan and your current rate of interest is 10.85% per year and you have the option to switch to a lower rate of 10.60% per annum. Given that you have 15 years remaining on the loan tenure, your outstanding loan (principal) balance will be around Rs. 40.8 lakh and switching this to the lower rate will result in EMI reducing by Rs. 636 and a total interest cost saving of Rs. 1.14 lakh. If for the same loan, you only have five years remaining as the loan tenure, then your outstanding loan balance will be around Rs. 21.2 lakh and switching this to the lower rate will result in EMI reducing by Rs. 275 and a total interest cost saving of Rs. 15,970. In any case, if your loan is 10 years old, then you probably got a better rate than current home loan rates.
So, switching your loan when you have a longer residual tenure is more lucrative than switching towards the end. The first few years of a loan are interest-heavy and this reduces towards closure of loan.
This refers to the incidental costs you will incur for switching a loan. “The switching cost a customer needs to consider while changing an existing loan is the sum of the prepayment penalty, if any, and the processing charges on the new home loan,” says Adhil Shetty, CEO and co-founder, Bankbazaar.com. While a number of banks abolished prepayment charges on floating rate loans sometime in the latter half of 2011, RBI formally issued a notice to that effect earlier this year. Which means now there is no prepayment penalty attached to your floating rate loan and to that effect your switching cost only consists of the processing fee in case of the new home loan. Some banks may charge prepayment penalty on older loans (on fixed rate and dual rate), so find out from your bank first. This is a big benefit if you have a large outstanding loan value; for example, a 2% prepayment penalty on an outstanding principal of Rs. 45 lakh would be around Rs. 90,000, which you can potentially save now. So switching your loan becomes that much more attractive.
The processing fee on the new loan can vary from around 0.25% to about 1% of the total outstanding loan amount, depending on the bank you choose and the total loan value. If the processing fee is lower than the total interest cost you save by making the switch, only then will it make sense to do it. Switching cost hurts more if the loan outstanding is of a higher value. But remember for a higher value loan outstanding your saving on interest cost will also be higher.
Combine, and assess
As a home loan customer, you really have to look at a combination of the three factors listed above. If you have 10 years left on your 20-year loan, a processing fee of 2% will make switching your loan unviable in all the three cases (original loan value Rs. 20 lakh, Rs. 45 lakh and Rs. 80 lakh) we tested. If the processing fee is up to 1.25% then go ahead. Running the same numbers for a residual loan tenure of five years showed that the switch is not viable for any of the above combinations; in fact, even if the processing fee is nil, the benefit of switching, in the case of an original loan amount of R20 lakh, is as low as Rs. 7,000. If the original loan amount is Rs. 80 lakh, the benefit is a mere Rs. 28,600.
Experts say other banks are likely to reduce rates. Vaibhav Agarwal, vice-president research, Angel Broking Ltd, says: “Clearly there is stress in the system as gross domestic product growth is slowing which is reflecting on demand. As disbursements to infrastructure projects are slowing and there is liquidity it is triggering lower rates across banks.” Since, the base rate hasn’t changed as of now for the industries, nothing changes. Moreover, current series of home loan rate cuts are not a result of lower policy rates — which may still happen.
Lastly, you can negotiate with your existing loan provider for lower rates. Says Suresh Sadagopan, a Mumbai-based financial planner, “If the trend is towards lower rates then eventually it’s likely that your own loan provider will reduce rates.” So, there may be no point in taking on additional paperwork and effort for a switch, unless there is a valid reason.