Earlier this month, the Reserve Bank of India announced a revision in the repo rate, which is the rate at which the central bank lends money to banks. The rate cut of 25 basis point (100 basis point equals one percent) brought the repo rate to 6.25 per cent. This was the first rate revision under the new RBI governor Urjit Patel, who arrived at the decision with the consensus of a six-man Monetary Policy Committee.
Any such rate revision will bring cheers to those repaying loans, especially a long-term loan such as a home loan. Even a small revision of 0.25 per cent could bring to them massive long-term savings to the aam aadmi. A downward revision also opens up a window in which loan owners can make focussed pre-payments and make significant reductions in their loan balance at lower costs.
Let’s take a look at what the repo rate cut means to loan owners, and what you could further do to make the most out of the situation.
Reduction in loan costs
A revision in the repo rate could impact you one of these two ways. One – if you’re servicing a loan taken before April 1, 2016, your loan would be linked to the base rate system. Your lender (bank or NBFC) decides how much of the repo rate cut of 0.25 per cent will be transmitted to you, leading to a reduction in your repayments.
Two – if you have a loan taken after April 1, it would be linked to the MCLR regime in which the lender must specify interest rates for tenors of one day, three months, six months and 12 months. This also means that the dates on which the rate revisions kick in have been specified in your loan agreement.
Let’s understand the implication of both scenarios through an example. Let’s assume you have a home loan of Rs 30 lakh for 20 years. It was borrowed at 9.50 per cent. Your EMI was Rs. 27,964. Assume that your lender will transmit the full value of the repo rate cut, bringing your interest rate down to 9.25 per cent. Here’s the EMI math following the cuts:
If your loan rate change reflects only through a chance in the loan tenor, your EMI would remain constant at Rs 27,964, and your tenor would reduce in this case.
(In this case, we assume that 12 EMIs have been made, and you had 228 EMIs left when the rate changed.)
Chance to make prepayments
A revision in interest rates presents a great opportunity to reduce a loan balance at an accelerated rate. During a period when interest rates are low, you could hasten your pre-payments, thereby paying off a larger part of your loan at a lower rate. This assures you greater long-term savings.
Doing this would also put you in a stronger position at any point the repo rate would start to rise again.
Let’s understand this with an example.
On the same loan of Rs. 30 lakh for 20 years at an interest rate of 9.5 per cent, let’s assume you have paid 24 EMIs of Rs 27,964. Your loan balance now stands at Rs 2,889,100.
At this point, the interest rate is revised to 9.25 per cent. Assuming no reduction in tenor, your EMI reduces to Rs 27,507, implying a monthly savings of Rs 457.
You should seize this opportunity to make a pre-payment. Let’s say you were to pay Rs 300,000 along with the 25th EMI, your tenor would reduce to 170 months from the remaining 216 – that means 46 months, implying long-term savings of approximately Rs 12.70 lakh.
Chance to switch
If you are paying a high rate of interest on your loan, it may be wise to switch to one offering a lower rate. You could switch to an MCLR-linked rate within your own bank at no cost or additional paperwork.
If you want to switch to an MCLR-linked bank at another bank, you will have to incur processing charges and fees on your loan balance. You could consider reducing your paperwork burden by going online to compare and buy loans.
While considering a transfer, do consider all costs of transfer and whether incurring such short-term costs can guarantee greater value in long-term savings. Only then is such a transfer justified.
A repo rate cut augurs well for loan owners who must make the most of this opportunity to reduce long-term liabilities. Small steps taken today could potentially create tens of lakhs of rupees in long-term savings.
The author is CEO, BankBazaar.com