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What should you do when your home loan interest rates go up?

This post discusses managing when interest rates go up increasing your home loan EMI.

What should you do when your home loan interest rates go up?


24 Apr 2022 - Contact Sayan Sircar
10 mins read

This post discusses managing when interest rates go up increasing your home loan EMI.

What should you do when your home loan interest rates go up?

Table of Contents

Introduction

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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Interest rates are going up

Chart: Arthgyaan • Source: RBI • Get the data

RBI, in line with other central banks, has hiked the Repo rate from 4.00% to 5.90% in quick succession:

  • 30-Sep-2022: RBI hiked the repo rate to 5.9% from 5.4%.
  • 05-Aug-2022: RBI hiked the repo rate to 5.4% from 4.9%.
  • 08-Jun-2022: RBI hiked the repo rate to 4.9% from 4.4%.
  • 04-May-2022: RBI hiked the repo rate to 4.4% from 4.0%.

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 linked Home loan rate = Repo Rate + Spread + Premium

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

Related:
This article explains how overall repo rate changes affect both borrowers and depositors.


Goal-based-investing plan

Change in EMI for increasing home loan rates

We will assume a home loan with a current rate of 7% and an outstanding balance of ₹50 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 ₹50 lakhs loan balance, then your annual EMI amount will increase by ₹29,125.

(click to open in a new tab)
Effect of interest rate increase

Quick calculator for checking your EMI

Please use the sliders below:

What about fixed-rate loans?

Fixed rate home loans are not an option

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:

Pre-pay = Outstanding_Balance * (1 - OldEMI/NewEMI)

A numeric example to explain this formula:

  • outstanding balance is ₹50 lakhs
  • old rate is 7%, new rate is 8%
  • old EMI is ₹57,502, new EMI is ₹59,929
  • ratio of EMI = Old/New = ₹57,502/₹59,929
  • prepayment of 50,00,000 * (1-57502/59929) = ₹202,500 will not increase the EMI

Read more on the topic of prepayment to ensure that it is the right thing to do in your case: Should you use your stock market profits to prepay a home loan?

Port to a different lender

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 bank’s 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 ₹44,941/month
  • EMI at 8% is ₹47,783/month

You can invest the difference of ₹2,842 in a debt fund via SIP to be used when the rate rises. Please use the table in the “Change in EMI for increasing home loan rates” 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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Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself
OR
use this quick and fast online calculator to find out the SIP amount and asset allocation for your goals.

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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


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