Over the last few quarters, the RBI has lowered the repo rate by 0.5 per cent, which has been followed by rate cuts by banks and lenders. This has resulted in lower home loan rates. In fact, the falling interest rate cycle has just begun. Rajneesh has a home loan of Rs 75 lakh that he took at an interest of 11.25 per cent. The tenure of his loan is 20 years.
Five years down the line, he wants to refinance his home loan for the remaining tenure at an interest of 10.50 per cent to take advantage of the falling interest rate cycle. Will this be a wise decision? The new rate is applicable for new borrowers and not existing ones. Should he opt for a balance transfer?
Many existing borrowers are looking to switch their home loan to another lender in order to take advantage of the new rate and lower their EMIs. When done properly, refinancing can be very beneficial.
However, before Rajneesh goes any further, he must carry out a thorough cost benefit analysis. It is important to time the loan refinancing in a way that saving on interest payable is maximised.
Rajneesh is likely to find switching lucrative as only five years of his loan tenure are over, which means a large portion of his principal is outstanding, as his EMI is mostly made up of the interest component. With time, the interest component comes down and principal component goes up.
There is no prepayment charge on floating rate loans, but some fixed rate loans may have it. Rajneesh must check if his bank will levy the same if he were to prepay and switch lenders. The loan processing charge of the new lender is the second part of the cost that should also be considered. A high processing fee may make the new loan quite expensive. Rajneesh must also consider the hassles of repeated paper work that goes into transferring the home loan from one bank to another.
Therefore, instead of making the switch decision by purely considering the interest rate differential, Rajneesh must make sure that he factors in all these costs when computing the potential savings. Needless to say, refinancing is a profitable move only when the potential savings in the long run are significant.
The content is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.