The Reserve Bank of India on Tuesday announced a repo rate cut of 25 basis points, pushing it to 6.25 per cent. It was a landmark cut not just for being the first one under the new RBI Governor Urjit Patel, but also because it is the first to have been decided unanimously by a six-member Monetary Policy Committee. Looking at the broader picture, the repo rate was at 8 per cent at the start of January 2014, and has come down by 1.75 per cent since then, thanks to the multiple downward revisions led by Patel’s predecessor Raghuram Rajan. There’s a feeling that the rate could go down further if inflationary forces remain reigned in.
Nevertheless, this is great news for everyone who is looking for a loan. This is Diwali come early for them, with the repo rate cut translating into lower interest rates on their loans, meaning smaller EMIs, larger long-term savings, and therefore money expendable income in their hands. Let’s take a look at how the repo rate cut will affect anyone taking a loan or owning a fixed deposit.
How much will you save on EMIs?
A repo rate cut would mean nothing to borrowers if the benefits are not passed on to them. For this, lending institutions must update their lending rates to transmit the benefits. Loans taken after April 1, 2016, are linked to the MCLR. Simply put, the MCLR regime ensures a degree of transparency and urgency in transmission of rate cuts by the RBI to borrowers with banks as the intermediaries. If you have taken a loan after April 1, your loan document would mention the dates (typically within six months or a year) at which your borrowing rate would be revised as per the prevailing lending rates.
Banks can also control the degree to which the cuts are transmitted. For example, one of the leading banks has an MCLR rate of 9.05 per cent from October 1, 2016. Currently, the bank’s home loan rate includes a credit spread of 25 base points, taking the actual interest rate on the loan to 9.30 per cent. Assuming that the bank transmits the full 0.25 per cent rate cut to its borrowers, here’s how much borrowers can expect to save on a 20-year home loan (see table).
How can you switch to lower rates?
Assuming you’re paying a higher rate and want to switch to a cheaper loan, there are several scenarios that can unfold. If you are on a base rate-linked or a fixed interest rate plan and want to switch to the MCLR regime within your own bank, you can do so without additional paperwork or processing charges. If you want to switch to an MCLR-linked loan at another bank, you will have to pay administrative and processing charges. You could also do away with the need to go through the cumbersome paperwork by going online to compare various loans available and choosing the one best suited for you.
While considering any of these options, use a loan payment calculator to understand what your long-term savings will be after making a switch. Do deduct the transfer costs from these savings to arrive at the most correct value of your savings.
There’s another option for existing loan holders, which is to pre-pay or pre-close their loans. This is particularly relevant in this particular macroeconomic scenario. Here, you’re paying in the range of 9.3 per cent for home loans, around 10 per cent for auto loans, and upwards of 12 per cent for personal loans. But on the other hand, your fixed deposits are earning post-tax returns of around 5.2 per cent. Therefore, it makes sense for you to limit investing in deposits and make the most of the low loan interest rates by making principal payments on your loan. Repaying the loan at a lower interest rate can create significant long-term savings for you while also reducing your loan tenure.
For example, assume you have a Rs 30 lakh loan for 15 years being repaid currently at an interest rate of 9.4 per cent. Your current EMI is Rs 31,146. If you made a pre-payment of Rs. 200,000 today, your tenure would reduce by approximately 23 EMIs, which implies long-term savings of nearly Rs 725,000. Reducing your loan balance while interest rates are low will help you make great progress in repaying your loan, and this will strengthen your position during a time in the future when interest rates will be trending upwards.
While most banks may not charge you for pre-payments on home loans, lenders do tend to ask for a price for pre-paying on car or personal loans. Consult your lender to get a better idea of the charges, and do leverage your relationship with your lender to negotiate a discount or waiver on these charges.
Bank deposits: poorer returns
Fixed deposits are a crowd favourite. They offer security of capital and conservative rate of returns. But they are not very tax-efficient, and your rate of return on new deposits will reduce with the latest repo rate cuts. Current deposit rates are hovering around 7.5 per cent. Assuming you earn more than Rs 10,000 rupees in interest from all your bank accounts and deposits, and assuming you fall in the 30 per cent tax slab, your effective returns on a deposit returning 7.5 per cent would be 5.2 per cent after tax. After the recent rate cut, let’s assume the average returns on fixed deposits would come to around 7.25 per cent, meaning that your post-tax returns would plummet to 5 per cent, which is below the current inflation rate hovering around 6 per cent.
What should you do in this scenario?
You could consider mutual funds. Gilt funds and liquid funds emerge as smarter options. They ensure liquidity and better returns than fixed deposits. Gilt funds have an inverse relationship with the interest rate: they earn better returns while interest rates go down.
Author: adhil Shetty is CEO, BankBazaar.com
Credits The Indian Express