The real estate industry in India has been in dire straits for some time now. Owing to a high interest rate structure, the real estate market hasn't seen much uptick in recent years. However, in the last few quarters, the RBI has lowered the repo rate by 0.5 per cent, followed by rate cuts by banks and lenders. This has resulted in lowered home loan rates for borrowers. However, as often happens, the new rate is applicable for new borrowers and not for the existing borrowers.
Many existing borrowers would look to switch their home loan to another lender in order to take advantage of the new rate and lower their EMI. This is also called refinancing. In this article, we will discuss when to switch your home loan or refinance your home loan.
Why refinance your home loan
Borrowers refinance their home loan to avail lower interest, which lowers their EMI as well. The EMI savings can be channelized into other investments, which will earn additional returns. Otherwise too, borrowers can maintain the same EMI with lower interest rate, thus reducing the tenure of repayment.
The other reason for refinancing is to change the interest type. Interest rate is of two types: fixed rate, where the interest rate is fixed throughout the tenure of the loan, and floating rate, where the interest rate changes as per the change in repo rate by RBI and subsequent bank rate cuts.
For example, if a borrower has taken a fixed rate loan and thinks that RBI would reduce rates going forward, it may be beneficial to switch to a floating rate scheme. Similarly, if a borrower has taken floating rate, he or she may want to switch to fixed if there is possibility of upward revision of interest rates in future.
Switching comes at a cost
Switching your loan comes at a price. Banks usually charge a one-time fee for switching loan type, which can be as high as 1.5 per cent of the amount. Few banks charge a fixed amount that is anywhere between Rs 5000 to 15000. When existing borrowers go for refinancing, they tend to ignore this cost and focus just on interest rate.
Few banks allow borrowers to switch their loan to the new rate at the same bank. It does come at a cost though. The banks charge a conversion fee for this. The conversion fee can be as high as 1-2 per cent of the loan outstanding. This could be a better option in many cases because there will be no documentation hassles. Hence, while switching the loan, consider converting your loan type with your existing lender. As long as the conversion fee is 1 per cent or lesser, and no paperwork is required, it may be smarter to stick with the existing bank. Else, you could switch to another bank.
How to assess the advantage of home loan refinancing
The first way to assess the advantage is by simply looking at the interest rate and check the difference in EMI. If this is significant, borrowers should go ahead with refinancing.
But, interest rate differential is just one parameter. To see the complete picture, borrowers must consider the total outflow in the new rate, including processing charges and fees. So unless the interest rate differential is not good enough to take care of expenses occurred in refinancing, there is no point.
It is also important to time the loan refinancing. As a home loan borrower, your EMI consists of higher interest part and low principal part in the beginning of tenure. As time goes by, the interest component comes down and principal goes up. The purpose of refinancing is to save on EMI outflow. Hence refinancing your loan in the beginning of tenure or the early part of the tenure will save you more.
Finally, refinancing serves to save on your EMI or reduce the tenure. Many borrowers go to the extreme of reducing the tenure by increasing their EMI. This aggressiveness may backfire. Limit the EMI outflow to a maximum of 50% of your income including all EMIs.
A small case of refinancing
Let's say a home borrower has 10 lakh outstanding for next 10 years at an interest rate of 11 per cent. The EMI outflow is Rs. 13,775. The outflow in the next 10 years will be 16.52 lakhs. Suppose the home borrower approaches another bank to refinance his home loan and the rate of interest is 10.50 per cent. In this case, the EMI will be Rs. 13,493. The total outflow in 10 years will be about 16.19 lakh.
The savings by purely looking at interest rate differentials is about Rs 33,000. Suppose the refinancing charge is 1 per cent of the loan outstanding, i.e. Rs 10,000. In this case, the benefit is even lesser. Add to this the procedural hassle and documentation that the borrower needs to go through, and it is evident that one needs to go beyond mere interest rate or EMI differentials to decide on whether to switch their home loans to another lender or not.
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