How Banks play with your Home Loan EMI?

RBI has taken another slew of  measure to stimulate Indian economy, cut repo rate at which it lends to the commercial banks  with marginal gap  by 25 basis points which reduced the existing Repo Rates to 6.25% from 6.50%. On the surprise move and sudden fall of repo rate, every borrower is expecting to bring down his EMI on the floating home rate. Although inflation was eased, the cut in repo rate is good news as it is likely to lower the cost of borrowing for both individuals and corporates. But, this good news has followed by very few banks on RBI’s cue because it is not compulsion for all bankers to pass on the benefit of rate cut to all categories of borrowers. The good news, however, is that leading banks may tweak their rates to woo more customers. In the last one year, home loan rates to retail borrowers have remained static in the range of 9% to 10% p.a.

Take an instance of a home loan borrower of Rs 40 lakh for tenure of 20 years, charges and EMI of Rs 38,600 at 10%. On the recent repo cut by 50 basis points, if the interest rate would also fall aligned with repo rate cut as to 9.50%, the EMI should be reduced to Rs 37,285. But it is a mirage for borrowers that rates will be recalculated on their EMIs something like that. Because after engaging with your home loan, each month you have to pay your EMI comprises with principal and interest component. You have ever seen that, as the RBI increases rates, your bank also raises your interest rate and vice-versa. Subsequently, let’s say it is charging 10.5% pa but is offering new customers much lower rates of 9.25%-9.50% pa. In another aspect, despite paying higher EMI every month for two years, your outstanding balance is still continued to remain high. Such outbursts by people who have already been taken home loan feel ‘cheated’ by such anomalies. There are numerous things to be done while taking the home loan and after taking the home loan; hence you should know about your home loan that how the bankers take the benefit of customers on any move of any RBI policy which may create tiffs with lenders and even after that.

Old Customers are charged higher interest rates than new Customer

Before July, 2010, banks used PLR (Prime Lending Rate) to offer their most creditworthy retail customers which was too much higher than subsiding corporate customers. Then, RBI introduced the base rate system in which banks can not lend below that rate. Ever since, all loans by banks are linked to their base rates. Banks arrive at the base rate after looking their cost of funds and other factors. Their base rates are kept under review at least once a quarter, floating rates may go up or down based on the call taken by each bank. That is why; each bank has different interest rates.

Your interest rate is usually set on base rate plus margin, for example, if the base rate is 10% and its margin 50 basis points or bps, then bank would charge you interest rate 10.50% from your home loan. The base rate may change but the bank cannot alter the spread or the margin at which it has offered loans to existing customers. So, if the base rate comes down from 10% to 9.75%, the interest for existing customers will fall from 10.50% to 10.25% while considering a spread of 50 bps. However, banks can offer new loans at a higher or lower margin, say base rate plus 25 bps. So for a new customer, the rate will be @ 10% (base rate 9.75% plus 25 bps) while old customers will remain continued to pay @ 10.25%. However, those differential rates may happen with a few lenders but is not a general practice. Actually, it depends upon the price methodology followed by individual lenders.

Initially your Outstanding Principal reduces at a very slow pace

It does not matter how high or low your EMI and being paid on your loan, its interest component will remain very high in the initial years due to the higher rate of interest or longer loan tenure.

Let us consider that you have taken a loan of Rs40 lakh for 20 years at an interest rate of 10%. Your EMI will be Rs38,600. After two years, the outstanding principal will be Rs38.60 lakh. For Rs9.26 lakh that you have paid in these two years, the principal will fall by paltry sum of only Rs1.40 lakh. In the first five years, only 17.6% EMI will go towards paying the principal. In the first 10 and 15 years, only 23% and 31.5% EMIs respectively, will go towards payment of the principal.

You will see that the reduction in principal is very much slower than interest component in the first few years. That is why; it makes sense to prepay the loan during initial years instead of later years.

Banks insist on changing loan tenure instead of EMI

You often see that while RBI either cuts or raises interest rates, as the case may be, your EMI remains the same for the entire loan tenure because it’s principal and interest ratio that keep changing. Lenders always prefer to change the tenure than change in the EMI. The reason is obvious as lenders have their own convenience. They do not heed the hassles of readjusting the EMI, changing the ECS mandate and accepting new post-dated cheques. When rates fall, reducing the tenure is beneficial for the borrower, as the interest cost falls. However, when rates rise, a longer tenure means you pay more interest.

Staying with above example, say after three years the rate is revised from 10% to 9.5%. If the EMI remains the same i.e Rs38,600, the tenure of the loan will come down by 15 months. You pay Rs35.27 lakh, in interest for the rest of the tenure (189 months).

However, if the EMI is re-adjusted and the tenure remains the same, you pay Rs38.52 lakh in interest during the rest of tenure. Thus, Rs3.25 lakh is more than the interest paid during the shortened tenure.

Paying more interest than the principal loan amount

Many borrowers do not realize that a house bought on a loan will cost them more than double the price tag. The longer the tenure, the higher will be the interest payments and higher will be the chance that you will pay more interest than the principal.

At 8%, you pay Rs40.30 lakh as interest on a loan of Rs40 lakh if the loan tenure is 20 years. To maintain double price tag, if the tenure is 15 years at rate has to be 10.6% and for 10 years at 15.9% rate at which the interest will be more than double the principal.

 Fixed interest rate on loans not really fixed

Generally, a fixed rate loan should remain fixed throughout the tenure. However, some lenders do have a reset clause saying that the rate is subject to revision. The clause ensures decent cash flow for banks if there is any sharp increase in their cost of funds and varies from bank to bank and is involved either after a fixed period or a sharp spike in interest rates.

Conclusion

The idea behind base rates is to ensure a fair and transparent system. But, this purpose is defeated if banks continue to tweak the rates arbitrarily. So, before opting for a home loan, it is always advisable to assess the impact of taking a loan and the subsequent EMI payments on the changes of RBI monetary policies and bank regulations as well. It is a prescribed personal finance practice to get a new monthly budget in place which accommodates the new cash out flow in the form of EMI payments. Therefore, it makes sense to access your affordability and the loan’s impact on your personal finance before opting for a home loan.

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