Higher EMI or longer tenure? Go by your financial wherewithal
A floating-rate loan appears to be better bet than its fixed-rate peer at present
On August 18, 2023, the Reserve Bank of India
(RBI) issued a circular titled “Reset of floating interest rate on equated
monthly instalments (EMIs)-based personal loans”. Experts say that the latest
rulings will make the resetting of rates more transparent and allow greater
choice to borrowers.
Give options to borrowers
Earlier, when the repo rate went up, banks
would increase the tenure. When the headroom for increasing the EMI. All this
would happen automatically. The RBI has now made it mandatory for banks to ask
borrowers which of the three options they prefer: higher EMI, longer, tenure,
or a combination of the two. “Many borrowers who have the financial wherewithal
can now opt for an increase in EMI so that they are able to pay off the loan
within the stipulated tenure and save on interest cost.
A higher Emi, however, means less financial flexibility,
Indian Mortgage Guarantee Corporation (IMGC), “The higher monthly burden would
impact free cash flow and the borrower’s ability to invest for other goals.”
Elongating the tenure means more cash in hand,
and greater flexibility to spend or invest, but results in a higher interest
cost. Borrowers must look at their financial ability when making a choice.
Options to switch to a fixed-rate loan
RBI has made it mandatory for banks to offer
borrowers the option to switch to a fixed-rate loan whenever interest rate is reset.
Currently, only a handful of lenders offer fixed-rate loans. Pricing the risk of a fixed loan over 20-30
year tenure is difficult. To factor in this risk, fixed-rate loans are
expensively priced. “Their interest rates are at least 2.5-3 percentage points
higher than that of floating-rate loans,”
Fixed-rate loans, though, have their benefits
too. “They off peace of mind. Borrowers know that their monthly outgo will
remain constant and they will be able to repay the loan by a fixed date,” However,
remember that lenders are allowed to charge a prepayment fee in these loans.
Experts currently favour sticking to a
floating-rate loan. “Why lock into a fixed-rate loan when interest rates are on
the higher side? Moreover, they could start descending in a few months. The
fixed-rate option should be examined when interest rates are near the bottom of
the cycle. “Even at that point, borrowers should be detailed calculations to
see which of the three options is most attractive: staying in the floating-rate
loan and prepaying; refinancing and moving to a lower-cost floating- rate loan;
or moving to a fixed-rate loan that is 2.5-3 percentage points higher.”
The repo rate has gone up by 250 basis points
in the current cycle. While loan rates of existing borrowers have gone up by
the same amount, rates on new loans have increased by a lesser amount as
several banks have reduced the spread on their loan. Borrowers (especially
those on loan linked to older benchmarks) must examine the option to refinance.
Few borrowers allow their loans to run the full
20 year course.” Most prepay within 7-10 years. Therefore, it may not make much
sense to pay a much higher rate of interest if you are planning to prepay and
pay off the loan early. In the case of a fixed-rate loan, check whether it is
fixed for the entire tenure. “Many such loans have a fixed rate for only the
first few years.
Make simple account statement available
The RBI has asked banks to make a simple
account statement available at the end of each quarter. This statement must
include the following information: principal and interest recovered to data,
EMI, number of EMIs left, and the annualised rate of interest or the annual
percentage rate for the entire loan tenure. “The RBI is basically saying that
the key terms and conditions of a loan should not be hidden in the fine print”.
Raghaw suggest that borrowers check their statements regularly and stay
informed about their loan’s key parameters.
NO PENAL INTEREST TO BE PAID
Suppose a borrower has a EMI of, say, Rs 100,
and his interest rate is 8%.
When he defaults the bank levies a fine of Rs
10; this is the penal charge.
Many banks were, in addition, charging a penal
interest; in this example, if the penal interest was 100 basis points, the
borrower’s interest rate would go from 8 to 9%.
RBI has said that while banks can levy a penal
charge, they can’t levy a penal rate of interest.
Banks can also not capitalise the penal charge.
If the penal charge of Rs 10 is not paid and
the borrower’s defaults for a second month, the penal charge can increase from
Rs 10 to Rs 20, but it can’t be added to the principle (the principal can’t go
from Rs 100 to Rs 110).
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