Interest rates have been going down for over 18 months now. If you have taken a home loan, your bank would have passed some of this benefit to you in the form of lower interest rates.
Usually, the banks are reluctant to pass on the lower interest to the borrowers. However, regulations allow borrowers to move to a different benchmark (base rate to MCLR to Repo rate linked loan) by paying a fee. Yes, the banks charge a fee for this. In some cases, the fee is nominal, which makes the decision easy. In others, the fee quantum is high, and you must do a cost-benefit analysis.
In this post, let’s consider two examples. One shared by a blog reader (Manjunath) and the other one by one of my investors.
Outstanding loan: Rs 37.94 lacs.
Outstanding Loan Tenure: 221 months
EMI: Rs 35,455
Rate of Interest: 9.1% p.a.
Switch offer: On paying a fee of Rs 1.23 lacs, you can reduce your interest rate from 9.1% to 8% p.a.
Outstanding loan: Rs ~67 lacs.
Outstanding Loan Tenure: 154 months
EMI: Rs 70,376
Rate of Interest: 8.2% p.a.
Switch offer: On paying a fee of ~Rs 3,000, you can reduce your interest rate from 8.2 % to 7.1% p.a.
As a borrower, what should you do?
Should you take the offers or let them pass?
In this post, let’s look at various approaches to see if you should accept these switch offers.
Approach 1: How long it takes to recover the switching fee? (EMI Constant)
This approach is intuitive, although a bit crude. This is the one I use to make a quick judgement about whether the deal is good or not.
You have paid a switching to reduce your loan interest rate. How long will it take you to recover the switching fee?
The longer it takes, the worse it is to switch.
Loan 1: The interest rate goes down from 9.1% to 8.0%. The current loan outstanding is Rs 37.94 lacs. If you multiply the loan outstanding by 1.1%, it gives approximate savings of Rs 41,700 over the next 1 year.
The switching fee is Rs 1.23 lacs. So, it will take about 3 years to recover the fee. (Rs 1.23 lacs/Rs 41,000).
By the way, I have used a crude calculation. The actual interest savings will be Rs 42,885 in the first year, Rs 45,451 in the second year and Rs 48,135. Lower interest pay-out means higher principal repayment (assuming EMI remains constant) and hence loan repayment gets expedited.
3 years to recover the fee or not. Is it good or not?
Difficult to comment. We shall see later why 3 years for fee recovery is unlikely a good decision.
Loan 2: The interest rate goes down from 8.2% to 7.1% p.a. The current outstanding is Rs 66.8 lacs. Rs 66.8 lacs X 1.1% = Rs 73,500.
And you have to pay only Rs 3,000 for switching. So, you recover the switching fee within a month. In fact, you save over Rs 6,000 in interest in just the first month. So, the decision to switch in this case is a no-brainer.
Approach 2: How long it takes to recover the switching fee? (EMI Changed)
What if we changed the EMI?
Loan 1: EMI goes down from Rs 35,455 to 32,868 (tenure remains constant at 221 months). You save Rs 2,586 per month. It takes ~48 months (Rs 1.23 lacs/Rs 2,586) to recover the fee.
The savings over the remaining 173 months (221-48) are your true savings. Hence, it looks like a fine decision (if there is no other option).
Loan 2: EMI goes down from Rs 70,376 to Rs 66,329. You save ~4,000 each month. Your switching fee is Rs 3,000. You recover the fee in the first month.
Approach 3: Switching fee is your investment. EMIs saved are your return
When the loan interest rate is reduced, the EMI does not usually go down. The loan tenure is reduced.
In Loan 1, the number of EMIs goes down from 221 to 188. You save 33 EMIs (32.84 EMIs to be precise) by paying a fixed fee of Rs 1.23 lacs. Over the loan tenure, you will pay Rs 11.64 lacs less.
However, you pay the switching fee upfront while the EMI savings come towards the end of the loan tenure.
How do we decide if the deal is good enough or not?
Let us assume you make an investment of Rs 1.23 lacs. You get Rs 35,455 starting from the 189th month until the end of 221st month. That’s exactly what you are doing, aren’t you?
What is the IRR for this investment? If the IRR is high, then your investment is good, and you must pay the switching fee to move to a lower rate.
The IRR (annualized) is 13.3%, which is a good rate of return.
Hence, paying the fee to shift to a lower interest rate looks like a fine choice.
In Loan 2, the number of EMIs goes down from 154 to 140 EMIs. You save Rs 9.71 lacs by paying a fixed fee on only ~Rs 3,000. The IRR is 48% p.a.
You can use Loan Calculator on EMICalculator.net and excel IRR functions for such calculations.
Approach 4: Assume Prepayment
What if you use the switching fee to make the prepayment (and not change the interest rate)?
If, by making the prepayment, your loan gets closed in lesser number of EMIs than by switching to a lower rate, switching to a lower rate is not a good choice.
Loan 1: If you make a prepayment of Rs 1.23 lacs, the loan gets repaid in 203 months (interest rate remains at 9.1%). Had you switched to a lower rate by paying a fee, you would have finished the loan in 188 months. Hence, switching is a better decision than prepayment.
Loan 2: I will not focus much here because the switching fee is quite low. The decision to switch is obvious.
But we are missing a big point here
For Loan 2, the decision is simple. Pay the fee and move to a lower rate. All the approaches give an objective verdict.
For Loan 1, the decision is not as simple. Depending on the approach considered, you take 3 or 4 years to recover the fee. Can’t say if it is good enough.
Home loan borrowers like to close their home loans as soon as possible. Many borrowers close their loans in 7 to 9 years.
Does this affect your decision?
Yes, it does.
Because when you prepay the home loan, you reduce the benefits of a lower interest rate.
The interest savings depend on the outstanding principal and the loan tenure.
Higher the loan outstanding, greater the benefit due to a lower interest rate.
Longer the loan tenure, greater the interest savings due to a lower interest rate.
When you prepay (or part prepay) the loan, the outstanding loan amount (and concomitantly loan tenure) goes down.
Let’s consider an extreme example.
Loan 1: We saw earlier that you saved ~Rs 41,000 in the first year due to a lower interest rate. If you prepaid the entire loan at the end of first year, your total savings from this exercise are limited to Rs 41,000. And you paid Rs 1.23 lacs for this benefit. Does not make sense, does it?
That’s why your plans to repay the home loan are an important decision factor in deciding to switch. If the switching fee is high (as in Loan 1) and you plan to prepay the loan soon, it might be a good choice to use the fee amount for loan prepayment.
Let’s consider more practical scenarios.
You plan to repay the loan in 7 years. You prepay Rs 3 lacs at the end of each year. At the end of the 7th year, you close the loan by paying the outstanding amount.
Loan 1 Scenario 1: You pay the switching fee of Rs 1.23 lacs to move to a lower rate. At the end of the 7th year, you will need to pay Rs 2.54 lacs to close the loan.
Loan 1 Scenario 2: You do not switch to a lower rate. Instead, you use the fee amount to part prepay the loan. And then prepay Rs 3 lacs at the end of each year. At the end of the 7th year, you will need to pay Rs 2.82 lacs to close the loan.
The difference is not much.
Hence, the switch offer made by the lender in Loan 1 is not really an attractive offer.
By opting for a lower rate, you also let go of flexibility. Switching fee, once paid, won’t be refunded. Remember, you may want to close the loan sooner.
What should you do?
Loan 2: The decision is easy. Pay the fee and switch to a lower rate.
Loan 1: Consider your prepayment plans. If you plan to close the loan in the next 5-7 years, switching to a lower rate does not appear an attractive option. The switching fee is extremely high. In such a case, you can approach another lender to refinance this loan.
I understand refinancing will require much higher effort on your part. In addition, there will be processing fee and ancillary charges. You need to make that judgement.
Don’t forget to ask your bank for the offer
Awareness helps. More so in this case.
The banks are unlikely to reach out to you to make these offers.
Why will they accept a lower interest for the same loan?
You must reach out to them.
Whether they will make a good switching offer or a bad one is a secondary matter. You must ask.
Let’s consider the cost of delay in Loan 2.
In the table below, I show the cost of delay in switching to a lower rate. If you delay the switch by 1 year, your principal outstanding will be higher by ~ Rs 74,000 and you will need 2 more EMIs to close the loan.
Hence, be aware and don’t hesitate to ask.