Soften The Blow

In the last couple of years, interest rates hit rock bottom with the Reserve Bank of India (RBI) and the government focused on infusing liquidity in view of the Covid-19 pandemic. As such, home loan borrowers became used to paying less for their biggest assets—their homes.

It’s no secret that your house will now cost you more with home loans becoming costly and expected to only become costlier going forward. The storm has only started and it’s only a matter of time before it hits harder. While you cannot  escape from paying more for your home loans now, you can soften the blow of the rising interest rate storm.

Pay a little extra either through part prepayment or increased equated monthly instalments (EMIs), and to be able to do that, sync your lifestyle with your cash flows and save more.

Changing Tide

It’s important to understand that interest rates will only go up, at least in the next couple of years. RBI has already raised repo rates twice—first by 40 basis points (bps) in early May and then by another 50 bps in its June policy announcement. But that’s not all. It has also indicated that it’s not going to hit pause on the rising rate regime anytime soon.

Once the repo rate goes up, the banks and non-banking financial companies (NBFCs) start passing on the rate hike to borrowers. Several lenders such as HDFC, State Bank of India, ICICI Bank, Punjab National Bank and Canara Bank have already hiked lending rates across tenures.  

The existing repo rate at 4.9 per cent is still much below the pre-pandemic level of 5.15 per cent. Rating agency Crisil expects RBI to increase the repo rate by another 75 bps this fiscal year, taking it 50 bps above the pre-pandemic level. SBI’s Economic Research Department sees the peak repo rate at 5.5-5.75 per cent. “The RBI could… take it higher than the pre-pandemic level to 5.25 per cent by August, and to 5.5 per cent in October. Our peak rate at the end of the cycle could go up to 5.75 per cent depending on inflation trajectory,” says the report.

Will Prepayment Make A Difference?

All EMIs have two components—the principal and the interest amount. Prepaying can make a substantial difference to your interest outgo.

For instance, if you have a home loan of Rs 50 lakh at 7.25 per cent interest over a 20-year period and you make a prepayment of Rs 2 lakh after one year, your interest burden will reduce by Rs 5.73 lakh. This means that your total interest outgo will reduce from Rs 44.84 lakh to Rs 39.10 lakh.

If you increase the prepayment amount to Rs 5 lakh, your interest outgo will reduce by Rs 12.30 lakh. For a prepayment amount of Rs 10 lakh, the outgo will reduce by a huge Rs 20.98 lakh.

In other words, the higher your prepayment amount, the higher will be the saving on your interest outgo.

When Should You Prepay?

The answer to the question depends on how old your ongoing loan is.

In the above example, we have assumed that the prepayment is done after a year. That said, if you don’t prepay early on, the savings will be much less. That’s because the component of the interest amount in EMIs is higher in the initial years.

In the same example, the saving in interest outgo on prepayment of Rs 2 lakh will reduce to Rs 3.67 lakh, and a measly Rs 81,874 if you prepay after five and 15 years, respectively.

Typically, avoid prepayment if your loan tenure is closer to end. “We believe the optimal pre-payment is 5 per cent of the loan balance once a year, assuming a constant rate. Your 20-year loan can be paid off in around 12 years this way. You could always go faster if you want, and if rate spikes are substantial, pay more than 5 per cent. But we believe 5 per cent is optimal because it makes your EMIs more effective. You’re also left with cash for investment, which is also important,” says Adhil Shetty, CEO, Bankbazaar.com, a banking aggregator.

Another factor to consider is taxation. The interest on home loan is eligible for tax deduction under Section 24(b) of the Income-tax Act, 1961. However, the tax benefit is limited to Rs 2 lakh per annum. So, if your annual interest amount remains less than Rs 2 lakh, you may avoid making part-payment. However, if the revised EMI after the rate hike shoots above Rs 2 lakh (on an annual basis), it makes sense to part-pay the principal amount and reduce the overall interest burden in the coming years.

V. Swaminathan, executive chairman of loan distributor Andromeda and Apnapaisa, explains this with an example. “The total interest outgo in a year for a Rs 50 lakh home loan at 7.50 per cent comes to Rs 3.7 lakh. Considering the tax exemption under Section 24(b), an additional Rs 1.7 lakh would not be covered. Thus, it is  advised that one should part pay the principal amount and maintain their existing EMI for another financial year,” he says.

Another tax benefit to consider is the one on principal repayment under Section 80C up to Rs 1.5 lakh. “If it is less than Rs 1.5 lakh, an individual can also include the stamp duty and registration charge paid for the same property,” says Swaminathan.

What Should You Do?

Shetty says there are ways in which one can become debt-free if one aspires to be so within a time frame. “If you plan to be debt-free in 10 years, refinance to a lower rate (if your Cibil score is more than 800), voluntarily increase your EMI, which will help you make small prepayments, systematically prepay something every year, or prepay a lump sum strategically to erase any additional months added by a rate hike,” says Shetty.

However, if you are unable to pay a lump sum, assess if you can afford to increase your EMIs further. For example, to make a prepayment of Rs 2 lakh per annum, you could increase your EMI by about Rs 16,000-17,000. If that is too much, you can settle for a lower amount too, but any amount of prepayment in the early years helps.

Do note that your EMIs would have already increased if you haven’t opted for a higher tenure, which is a costlier bargain. Banks usually extend the loan tenure to adjust the impact of rising interest cost. This helps them in earning more interest income. But it is a negative for borrowers, who have to pay more. Assuming a constant EMI, a 20-year loan at 6.5 per cent could become a nearly 24-year loan if the rate goes to 7.5 per cent, according to data shared by BankBazaar. At 8 per cent, it becomes a nearly 28-year loan.

To top that, the rising rate scenario brings with it higher inflation and uncertainty in terms of job opportunities. That is why it’s imperative to look at your cash flow.

“Inflation spikes and rate hikes correlate with volatility in various aspects of our financial lives. Real income gets smaller, and the cost of living goes up. So, prepay only if it doesn’t hurt other aspects of your financial life. For instance, if your savings are low, your employment is uncertain, and the rising costs of living are pinching you, it’s not a good idea to  go in for a prepayment,” says Shetty.

Swaminathan suggests switching to a floating rate loan as rates are expected to rise further. “After inflation is back to near normal levels, borrowers can make use of balance transfer to convert their fixed-rate into floating rate if the difference in rates is minimal and favourable to them,” he adds. However, you may have to contend with large amounts of paperwork when transferring your loan. It also makes sense to check the terms and conditions of fixed loans, some of which may not allow prepayment or only after a certain period of lock-in.  

The rate hikes over the next few months are a given. Plan your expenses and money management well to sail through the tough period. The sooner you get debt-free, the better your financial health will be.

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Costlier Loans

• Hike in May 2022: 40 basis points
• Hike in June 2022: 50 basis points
• Expected rise in FY23: 75 basis points
• Total rise at the end of FY23: 165 basis points or 1.65%

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When Should You Prepay?

1. When you have a longer tenure left

2. When annual interest amount is less than Rs 2 lakh

3. When your cash flows and other investments do not get affected

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