Hike EMIs, not tenors!

By | April 13, 2011

How loans become costly?

There are two main rates that are affected when RBI decides to increase or decrease the rates.

  • Repo rate : The rate at which banks borrow from RBI
  • Reverse Repo Rate: The rate at which banks deposit with RBI.

An increase in these rates will directly be, reflected on those who wish to borrow the loan. At present, The RBI has hiked the rates by 100 basis point. So, repo rates have gone up from 6.25% to 7.25% and reverse repo rates are at 6.25%, up from 5.25%.

How this will affect you?

With the increase in the interest rates, you will obviously have to pay more amount as interest on your loan. But if the loan is for a longer duration, say a home loan, whose tenor varies from 10-20 years, the total expense incurred will be quite costly.

What should you do?

In such situations, hiking the amount you pay for your EMIs should be considered rather that increasing the loan tenor. Considering the former option, you have the advantage of repaying the entire loan amount without any delays in the duration. Considering the latter, although, you may pay the same EMIs as you paid earlier before the hike, the total amount of the cumulative interest rates alone will be a huge burden on your pocket.

For example, you have a loan of Rs. 30 lakh at 9% for 15 years; you service the EMIs for six months and then the interest goes up by 1%. If you agree to increase your EMIs, your total cost of loan (principal plus total interest outgo) will go up to around Rs. 57.84 lakh from around Rs. 54.77 lakh at the earlier rate. But if you choose to increase the tenor to around 17.08 years (including initial six months) instead, your total cost of loan would notch up to around Rs. 62.39 lakh. In the same example, if the rate increase is 2%, the cost of loan goes up to around Rs. 60.99 lakh if the EMI is increased and around Rs. 75.17 lakh if the tenor is increased to 20.58 years (including initial six months).

Switching the lender can also be a suitable option in certain situations. But, you need to make a few calculations, before getting into such an agreement. First, find out the pre payment penalty of transferring your loan from your present banker. Second, find out the processing fees the new bank provides. After adding up these days two costs, you can shift to a new lender, only if the costs are considerably lower.

The best advice most financial advisors give to customers is that, in such of scenarios when the loan rates go up, it is best if you can manage to pre pay lump sum amount over the principle amount of your loan than your EMIs. With this, a huge burden on your savings is cut down. But, make sure if the bank has any pre payment penalty, after which you can make your call.

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