Home buyers should keep in mind that most home loan rates are floating i.e. the rate of interest will fluctuate over time. An increase in interest rates will increase the EMI and may cause a strain on the household budget or other investments for other goals.
This is an important consideration since currently, interest rates worldwide are going up due to higher inflation. In India, the marginal cost of funds-based lending rate (MCLR) is being raised, and loans (home/personal/car etc.) linked to MCLR are already going up. In addition, new home loans that are connected to the RBI repo rate (RLLR) are also at risk since RBI is expected to raise the repo rate from 4% to 4.75% by the end of 2022.
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RBI, in line with other central banks, has hiked the Repo rate from 4.00% to 6.50% in quick succession:
08-Feb-2023: RBI hiked the repo rate to 6.50% from 6.25%.
07-Dec-2022: RBI hiked the repo rate to 6.25% from 5.90%.
30-Sep-2022: RBI hiked the repo rate to 5.90% from 5.40%.
05-Aug-2022: RBI hiked the repo rate to 5.40% from 4.90%.
08-Jun-2022: RBI hiked the repo rate to 4.90% from 4.40%.
04-May-2022: RBI hiked the repo rate to 4.40% from 4.00%.
The hike is a part of inflation-taming measures put in place by global central banks. For RBI, the Repo rate is now rising towards the pre-COVID-19 pandemic days when the rate was 5.15%. It was lowered twice in March 2020 (to 4.40%) and then again in May 2020 (to 4.00%) to negate the impact of the economic slowdown caused by the pandemic.
As inflation has been rising as the economy recovered, the repo rate rise was inevitable, and further rate increases are unavoidable. The RBI is planning more rate hikes.
The interest rate on your home loan will typically be a floating rate that will fluctuate with overall interest rates in the economy. Usually, the RBI repo rate movements indicate the direction of interest rates in the economy. At the same time, home loans are tied to the Repo Linked Loan Rate (RLLR) or Marginal Cost of Funds-based Lending Rate (MCLR) as per RBI. As inflation increases, the central bank is expected to increase this year.
As interest rates fluctuate, so will your EMI over time. If rates increase, one of two things happen:
the EMI goes up, keeping the loan tenure constant
the loan tenure goes up, keeping the EMI constant
Any increase in the EMI will correspondingly cause an impact on your household budget, as we show below.
Home loans and their dependency on interest rates
We break down the home loan rate into its major components to see where the fluctuations come from.
Repo rate: This rate is decided by RBI. Home loan rates will move up and down as soon as RBI revises the Repo rate
Spread: This is an additional rate on top of the repo rate that essentially captures the profit the bank can make off this loan relative to the deposits it offers to customers. This rate is generally revised every three years but will vary from bank to bank.
Premium: an extra value for some specific customers. E.g SBI adds another 15bps for non-salaried customers or will depend on CIBIL score. This value is also revised periodically like every three years
We will assume a home loan with a current rate of 9% and an outstanding balance of ā¹50 lakhs. You can determine the impact on your loan by applying the unitary method. For example, if your due balance is one crore, you need to double the numbers in the table. The table shows the annual change in EMI due to both decreasing and increasing rates. The base case of no change in EMI is in the centre column of the table.
To explain the data, if the interest rate rises by 1% and 10 years is left for your ā¹50 lakhs loan balance, then your annual EMI amount will increase by ā¹29,125.
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Quick calculator for checking your EMI
Please use the sliders below:
What about fixed-rate loans?
Fixed rate loans seem to be a good solution to this problem. If the rates never rise (or fall), then you no longer have to worry about this problem. The EMI will always be the same. Except when they are not:
fixed rate loans generally have a clause for a reset in two years to bring them closer to market rates
at the start fixed rate loans are much more expensive than floating rate
If you are thinking to take a fixed rate loan, you will be better off with a floating rate loan and keep the difference in a EMI buffer fund as explained below.
What to do if rates rise?
You should perform an immediate portfolio review, including emergency fund review, as soon as the interest rate changes. To be on the safe side, use a slightly higher interest rate, say by extra 1%, when calculating the impact on goals and emergency fund amount when you are buying a house with a loan.
Prepay based on cash availability
You can offset a part of the increase by reducing the principal via pre-payment. This plan assumes that your current asset allocation for goals allows this to be done. If you have excess equity allocation, then only you can rebalance from equity into the home loan prepayment.
Pre-payment amount that keeps the EMI constant can be calculated as:
All lenders are not equally prompt in changing the rates as per the MCLR or repo rate changes, especially when rates are going down. However, when rates rise, they will probably be passed on to the borrower reasonably quickly since it is in the bankās interest to do so.
If you find that other lenders are offering lower rates, consider transferring with the caveat that those rates may also rise soon. On the other hand, if you are getting a better rate elsewhere, consider switching costs and customer service of the new lender.
Build an EMI buffer fund starting today
If you follow our goal-based investing plan for paying the home loan, you can adjust your home loan related goal for a higher interest rate. In addition, this plan will pull in an additional amount from other purposes to pay the loan. If your actual loan rate is lower than what you assumed it to be, invest the difference of the EMI in a debt mutual fund to be used when rates rise.
For example, for a 50L loan for 15 years,
EMI at 7% is ā¹44,941/month
EMI at 8% is ā¹47,783/month
You can invest the difference of ā¹2,842 in a debt fund via SIP to be used when the rate rises. Please use the table in the āChange in EMI for increasing home loan ratesā section above to check how much to save in the EMI buffer fund. The table shows yearly figures so divided that by 12 to get the monthly SIP amount.
If you cannot manage the EMI increase post the rate rise, please speak to the lender to increase the loan term.
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This post titled What should you do when your home loan interest rates go up? first appeared on 24 Apr 2022 at https://arthgyaan.com
