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How paying a small fee to your bank can save you lakhs in home-loan interest?

This article shows how paying a small fee to your bank to reduce your home loan rate can save you lakhs in interest over the life of your loan.

How paying a small fee to your bank can save you lakhs in home-loan interest?


Posted on 11 Oct 2023
Author: Sayan Sircar
12 mins read
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This article shows how paying a small fee to your bank to reduce your home loan rate can save you lakhs in interest over the life of your loan.

How paying a small fee to your bank can save you lakhs in home-loan interest?

This article is a part of our detailed article series on the concept of home loans. Ensure you have read the other parts here:

📚 Topics covered:

How a home loan works?

Mortgage payment vs home equity

The bank gives a home loan to own the property while you use it until you pay back the loan via EMIs. An Equated Monthly Instalment plan (EMI) is a standard way to pay off a loan by making a fixed payment monthly that has both interest and principal in the same amount.

EMI = Principal + Interest

In each EMI, the split of the interest and principal changes since the interest is based on the outstanding loan balance at that point and the rest of the EMI is principal. As the chart shows, the interest part drops off with time, and the rest is the principal. The actual numbers in the chart relate to a ₹50 lakhs home loan taken at 8% for 25 years. The EMI is ₹38,591. The down payment amount is ₹12.5 lakhs.

You can test the numbers using this calculator:

As you pay back the loan, your ownership share in the house will increase in the same way. At the point of taking the loan, you own 20% of the house (12.5 out of 62.5 of which 50 is the loan). The bank owns 80%. As the loan is repaid, you own more and more of the house as the principal is paid off. This is the concept of building equity in an asset. Equity is the part of the asset you own after subtracting the part that the bank owns.

Home equity value = Current home value - Outstanding loan balance

Once you build equity in your home, that has additional benefits:

  • you can take a top-up loan in case you need money for some other purpose like home improvement, or any other reason
  • the more you will get to keep if you sell the house

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

The latest repo rate is 6.5%. This rate was last reviewed by RBI on 08 Feb 2024.

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 the CIBIL score of the borrower. This value is also revised periodically like every three years.

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

This article discusses the situation where new home loan customers are being offered much lower rates than existing customers. New customers have the options of reducing the loan after approaching their lender.

We will now look at the benefits of reducing your home loan from 9% to 8.5% after payment of a small reduction fee.

One worked out example

We will now use a sample home loan to see what happens when you get the rate reduced. If you are using Excel to calculate your home loan EMI, the formula to use is:

EMI = PMT(rate/12,time * 12,-principal,0,0)) where time = years left to pay the loan

Interest paid = EMI * Number_of_EMIs - Principal left

Metric Value
Loan balance (₹ lakhs) 50
Old rate of interest 9.00%
Years left 15
Period left (months) 180
EMI 50,713
Total interest to be paid 41,28,399
New rate of interest 8.50%
Conversion fee 10,000
######## ########
Option 1: Lower duration
EMI 50,713
New period left (months) 170
Period reduction (months) 10
Total interest to be paid 36,21,266
Interest saved 5,07,133
######## ########
Option 2: Lower EMI
EMI 49,237
Monthly EMI savings 1,476
Conversion fee recouped 7 months
Total interest to be paid 38,62,656
Interest saved 2,65,743

As we can see, lowering the EMI has an immediate benefit whichever option you take.

Related:
What benefit do you get if you make a one-time prepayment to your home loan?

The lender, who gave you the home loan, benefits the higher the interest rate and the longer you keep paying the EMI. Banks will jack up the home loan rate as soon as the reference rate goes up.

As the borrower, your main incentive is to make the interest rate as low as possible, even after paying the conversion fee.

We will now look at various savings values for interest and time if you reduce the rate. These tables assume that the old rate is 9% and the new rate is 8.5%. The benefits of EMI reduction are shown below.

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How much EMI reduces if the home loan interest rate reduces?

This table shows the monthly EMI reduction when your rate reduces for various combinations of outstanding amount and loan period left.

EMI Reduction When Interest Rate Is Reduced By 0.5%

How much interest is saved if the home loan interest rate reduces and EMI is reduced?

This table shows the reduction in total interest when your rate reduces for various combinations of outstanding amount and loan period left. Here you are reducing the EMI you are paying (maybe to invest for long-term goals) and keeping the tenure same.

Interest Saved When Interest Rate Is Reduced By 0.5% and the EMI Is Reduced

How much interest is saved if the home loan interest rate reduces and the loan tenure is reduced?

This table shows the reduction in total interest when your rate reduces for various combinations of outstanding amount and loan period left. Here you are reducing the tenure to get rid of the loan faster.

Interest Saved When Interest Rate Is Reduced By 0.5% and the Loan Tenure Is Reduced

How much should you pay as the interest rate conversion charges?

Your objective should be lower the interest rate as soon as possible unless the conversion fee is extremely high. In such cases porting the loan might be an option which we will cover in a future article.

This conversion fee (plus 18% GST) is not regulated by SEBI or RBI (they have no reason to) and serve as the mental block for borrowers not to reduce their interest rate. Hopefully after reading this article, you know the benefit of lowering the rate even after paying the conversion fee.

How to ask for interest rate reduction?

Lenders offer multiple channels for contacting them like physical branch (or loan processing centre) visits, via app, on phone or via email. It might be even possible to get different offers based on the channel you are checking (branch vs app) and in some cases the fee could be negotiable.

What if the interest rate increases again?

RBI will raise repo rates as per its role as a central bank and home loan rates will follow. Even in such cases, a temporary reduction will be beneficial since the new increase in loan rate will be the same as the repo rate increase.

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This post titled How paying a small fee to your bank can save you lakhs in home-loan interest? first appeared on 11 Oct 2023 at https://arthgyaan.com


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