Don’t bank much on your bank for Tuesday’s rate cut. You’ve heard it right. A 0.25 per cent rate gift from the RBI is praiseworthy but for a home loan borrower there’s very little cheer.
The central bank’s new method to arrive at lending rate, known as the Marginal Cost of Fund Based Lending Rates (MCLR), stipulates that lending rates remain fixed for a particular tenure that is mutually agreed between the bank and the borrower. For home loan borrowers with flexible interest rate option, the rate reset may happen either after six months or a year. So, the October 4 rate cut may not be of much help to new borrowers till their reset period arrives in few months’ time.
The interest rate on home loans from banks after April 1 is linked to the MCLR. Few banks have announced the cut by lowering their MCLR. ICICI Bank’s one-year MCLR is at present (effective from October 1) at 9.05 per cent, while home loans are offered at 9.35 per cent (9.3 per cent for women borrowers). State Bank of India’s MCLR is at 9.05 per cent, while home loan rate is 9.3 per cent (9.25 per cent for women borrowers). Interestingly, one-year MCLR for ICICI Bank and SBI on April 1 this year was 9.20 per cent. Since then, it has come down by 0.15 per cent.
Under the base rate regime, banks were either reluctant to pass on the cut or did so with a time lag. The MCLR-based lending is almost similar but more transparent and frequent as banks have to disclose their MCLR on a monthly basis. Further, it is based on marginal cost of funds raised by banks and is more dynamic. Even pre-April 1 borrowers, who have their home loans linked to the base rate, may not see an immediate impact. However, taking the earlier 0.25 per cent rate cut (April 2016) along with the recent one (October), banks have the leeway to reduce their base rate. There could, however, be a time lag before banks reduce their base rate and help borrowers reduce their interest burden.
Now if you are borrower, that is a painful wait. There is, however, a solution in partial prepayments. You can use this to reduce their total interest loan cost. Partial prepayment refers to any payment made by the borrower in addition to the regular EMIs. It directly reduces the outstanding principal amount and the interest gets calculated on the reduced principal. Just like a Systematic Investment Plan (SIP) in mutual funds, one can create a Systematic Partial Prepayment (SPP) plan in home loans. While the former helps in creating wealth, the latter helps in saving interest. After all, a penny saved is penny earned.
How SPP helps
Prepayment helps in reducing the total interest outgo as the loan tenure gets reduced. Consider this: A Rs 40-lakh home loan at 9.65 per cent interest rate for 15 years with an EMI of Rs 42,131 has a first year interest of Rs 3.8 lakh, while total interest payout (assuming no change in rates) over 15 years comes to Rs 35.83 lakh.
Now, if the borrower, in addition to the EMIs, prepays Rs 10,000 every month only for the initial three years, the interest outgo gets reduced by Rs 8 lakh! That’s what you actually save, and the tenure also reduces to 12.75 years. The higher the prepayment amount and the longer the period, the more will be your savings.
Where to find funds for prepayment?
Lenders typically lend the loan amount in such a way that the EMIs are not more than 45-55 per cent of the borrower’s take-home pay. EMIs include all monthly commitments towards any other loans such as car and personal loans as well. Even while 50 per cent goes towards servicing loans, one may plan and set aside a certain amount that can go towards prepayments. If such a buffer is not available, a working spouse may pitch in towards prepayment. Any bonus, windfall, arrears may also be directed towards your loan prepayment.
What if you don’t opt for SPP?
Prepayments lower the final price of your property. Remember, every rupee that one pays towards interest gets added to the cost of the home. Sample this: A Rs 60-lakh home bought on loan, with a down payment of 20 per cent at 9.5% for 10 years, would cost you Rs 93 lakh (including interest of Rs 33 lakh). So after 10 years, if the market price of the property is around Rs 93 lakh, you just break-even!
Although it’s your own house and not an investment, still one would ideally like to keep the cost as low as possible and therein prepayment helps.
Prepay or invest?
Now if you have funds to prepay, you could have alternatively invested it somewhere. That’s the trade-off most borrowers could face. Here’s a probable solution. See if you can generate a return higher than what you are effectively paying on your home loan. Effective home loan interest rate means the rate after you have taken tax benefit on it. Here’s how to find effective home loan interest.
Considering the home loan as discussed above, the first year interest is about Rs 3.8 lakh, while only Rs 2 lakh is tax-deductible. So for someone in the 20% tax slab, on Rs 2 lakh, he is able to save Rs 40,000 as taxes in that year. Effectively, the first year interest payout becomes Rs 3.4 lakh (Rs 3.8 lakh minus Rs 40,000). The effective interest rate, therefore, is 8.51% (Rs 3.4 lakh upon Rs 40 lakh of loan). So instead of 9.65% home loan rate, you are paying 8.51%. So for someone in the 30% tax slab, on Rs 2 lakh, he is able to save Rs 60,000 as taxes in that year. Effectively, the first year interest payout becomes Rs 3.2 lakh (Rs 3.8 lakh minus Rs 60,000). The effective interest rate, therefore, is 8.01% (Rs 3.2 lakh upon Rs 40 lakh of loan).
Remember, it’s for the first year only and the amount reduces second year onwards. And if you have investment options that can help you generate more than 8.51 per cent per annum, it might look tempting to invest rather than prepay.
KEEP AN EYE FOR
Some banks offer overdraft home loan accounts. They open a normal savings account and any funds in it are treated as partial prepayments towards the home loan. There are, however, two drawbacks: One, the home loan rate could be a tad higher by about 0.25 per cent, and second, there is no Section 80C benefit. It, however, provides liquidity and funds can be tapped for any other purpose as well.
Generally, banks allow prepayment amount equal to at least one month’s EMI. In such cases, for SPP, prepare a plan to prepay every quarter or once in six months. There’s no fixed date to prepay. One can do so as and when funds are ready, but it has to be from one’s own sources. It’s better to find out other restrictions from the bank or lender before prepaying.
Cost of prepayment
The RBI had directed that banks will not be permitted to charge foreclosure charges/prepayment penalties on all floating rate term loans sanctioned to individual borrowers. To ensure that funds are from an individual’s own sources, the banks insist on an account statement.
Before making partial prepayments, make sure you have adequate emergency funds. Also, make sure that your other long-term goals such as children’s education, marriage and retirement are on track. If not, it’s better to start investing for them rather than prepaying the entire investible surplus.
Prepayment suits only those who have investible surplus and are not necessarily short of funds on a monthly basis. Individuals who are sole earners and have financial dependents have all the more reason to get rid of the debt as early as possible. Prepayment is the way forward in finishing off the loan at the earliest.
Credits ET Realty