# How Peachy Rate Cuts Affect Your Current Loans

By | June 10, 2015

Extra, extra! Good news is here and there’s no need to be puzzled anymore.

On 2nd June, RBI reduced the key repo rate by 25 basis points to 7.25%, the third such cut in the year. Other banks are now expected to reduce their lending rates once more.

Rahul, your average IT guy, was wondering how his loan Equated Monthly Instalments (EMIs) and loan tenure would change if there was a rate cut, just like you are.

Let’s compare how falls in the interest rates by 0.1% and 0.25% affect Rahul (and you).

BASE CASE:

XYZ bank offers home loans at 10.5% to its customers, which were at a 2% premium to its base rate of 8.5%. Rahul has borrowed a home loan from XYZ Bank to the extent of Rs. 50 lakhs at an interest rate of 10.5% for 240 months. The EMI works out to Rs. 49,919 per month. The total interest payable over the tenure of the loan in addition to the principal of Rs. 50 lakhs works out to Rs. 69,80,559.

CASE 1 – Fall in interest rates by 0.1%:

Assume that XYZ bank reduces its base rate by 10 basis points following RBI’s rate cut. After a reduction in the base rate by 10 basis points, the new base rate stand at 8.4%. Consequently, the interest rate on home loans fall to 10.4%.

On a fall of the interest rate to 10.4%, Rahul’s EMI automatically falls to Rs. 49,584 a month, a drop of Rs. 335 a month. The total interest payable falls down to Rs. 69,00,060, a fall of over Rs. 80,000 owing to a small fall of 0.1% in the interest rate.

In place of a reduced EMI, Rahul also has the option of reducing the tenure of the loan, while keeping the EMI amount constant. In this case, assuming Rahul keeps the EMI amount at around Rs. 49,901 per month, the tenure of the loan falls to 235 months. As a result, the total interest paid over the loan tenure falls to Rs. 67,26,718, a huge fall of a Rs. 253,841.

CASE 2 – Fall in interest rates by 0.25%:

In another case, assuming that XYZ bank reduces its base rate by 25 basis points, to 8.25%, the home loan rate also falls, by the same quantum, to 10.25%. Rahul’s EMI amount will now fall to Rs. 49,082 per month and the total interest paid stands at Rs. 67,79,721 – a reduction of Rs. 200,838. If Rahul prefers to keep the EMI amount constant at Rs. 49,918 (the base case scenario), the loan tenure falls to 227.5 months. Consequently, the total interest paid over the tenure of the loan reduces to Rs. 63,56,311 (a fall of Rs. 6,24,248).

In summary:

 PARTICULARS BASE CASE FALL IN INTEREST RATE BY 0.1% FALL IN INTEREST RATE BY 0.25% Interest rate 10.5% 10.4% 10.25% EMI amount at constant loan tenure of 240 months Rs. 49,919 Rs. 49,584 Rs. 49,082 Total interest when loan tenure is 240 months Rs. 69,80,559 Rs. 69,00,060 Rs. 67,79,721 Loan tenure at constant EMI amount of around Rs. 49,919 240 months 235 months 227.5 months Total interest when EMI is around Rs. 49,919 Rs. 69,80,559 Rs. 67,26,718 Rs. 63,56,311

Reducing the EMI amount or reducing the tenure, which one is the better option?

It is seen from the cases above that a fall in interest rates automatically means a fall in the monthly EMI amount you pay to the bank. Logically, the larger the fall in the interest rate, the higher will the difference in the EMI amount.

As far as monthly expenses are concerned, a fall in EMI means more cash in hand, and as a result, more opportunity to save. As a result, many borrowers opt for a fall in EMI when the interest rate falls. In fact, many banks make this a default option and automatically reduce the EMI amount.

However, as a borrower, reducing the tenure of the loan can bring down the interest amount you pay during the loan tenure.

The better option is a reduced tenure for the loan.

What happens to teaser loans when there is a fall in interest rate?

Teaser loans carry a fixed rate for a limited period (say the initial 1 or 2 years), and thereafter the interest rate is floating in nature. The fixed rate is usually much lower than the prevailing floating rate. For such loans, when there is a fall in interest rate during the fixed rate tenure, there is no change in the EMI or tenure.

Once the initial period is over, if the bank reduces the interest rate, the same principle as any other loan applies. That is, you can reduce the EMI amount or the tenure of the loan for a fall in the interest rate.

We hope that this hot news helps you buy those hot cross buns (or croissants) you’ve always wanted, while you pay off your home loan. How about some extra ketchup with that?

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