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Refinancing your loan

Most home loan borrowers are looking at refinancing their loan to reduce the EMI burden.

Written by Adhil Shetty | Published: September 17, 2011 1:55:53 am

Interest rates are up at unprecedented levels because of RBI raising policy rates 11 times in last two years. In some cases,the EMIs for home loan borrowers have gone up by 25-50 per cent during this period. In most cases,the tenure of the loan borrowers have been extended to help them cope with the additional burden of the rise in interest rates. This in turn will mean that interest outgo will be comparatively higher in the long run compared to borrowers who opted for a higher EMI.

Niranjan used to pay Rs 25,000 as EMI for his home loan. Today,he pays more than Rs 35,000 per month. This is despite no real increase in salary. In fact,if you factor inflation,the real income has gone down in last one year.

In such a situation,should you even think of refinancing you loan? Added to that is the penalty (good news is,this is likely to become a thing of the past very soon) which is imposed by most banks on refinancing. The answer is both yes and no depending on what deal you get. In this article,we will discuss how your EMI is repaid and the different facets of refinancing your home loan so that you can take a judicious decision on this crucial question.

What is an EMI?

An equated monthly instalment (EMI) is the amount of money paid back to the lender on a monthly basis. It is essentially made up of two parts,the principal amount and the interest divided across each month in the loan tenure.

Now,you might assume that the equal parts of the principal and interest is repaid to the financial institution every month,however this not the case. During the initial years the interest component repaid is higher and during the latter years of repayment,the principal component is higher. So,if you think you have paid half of the amount borrowed from the bank in 5 years in a 10 year loan tenure that would not be the case. You would probably have reduced the total interest component due considerably and would have only repaid the interest component for the most part.

Here is a simple example that explains how the repayment of your EMI reduces your loan amount during the repayment period leading up to the end of the loan tenure.

Remember to request your bank for an amortisation table,which will indicate at any point in time,what exactly your outstanding loan amount is.

Now that you have an understanding of how your loan is repaid,you will need to figure out how much of your interest has been repaid and how much is your outstanding loan amount. If you are well into your loan tenure,where you have repaid most of your interest due to the bank,it may not make sense to start a new loan where you will have go through the entire cycle again. So do factor this aspect as well,when you calculate and compare the total interest outgo from a loan switch.

The rationale of refinancing

Home loan borrowers refinance their loan for the following purposes.

* To reduce the interest rate and hence EMI and total interest outgo: This is the most important reason why borrowers go for refinancing.

* To switch interest types: This is again a very popular reason to go for refinancing. If borrowers have taken fixed rate loan and if they want to profit from declining interest rates,they may want to go for floating rate.

* To reduce the tenure of the loan: Few borrowers want to prepay or at least reduce the loan tenure and hence go for refinancing.

* To get a better deal: The refinancing bank could offer a better deal or could be quick to reduce interest rates in a downward trend.

Important factors

Interest rates: Needless to say,the rates should be lower than what you are being charged currently by the bank.

Cost of switching: While borrowers do look at the interest rate,they do not always take into account the cost of switching. Cost of switching has two major components.

Prepayment penalty: As of now,borrowers should consider the prepayment penalty that the existing banks would charge. Usually public sector banks charge 1 per cent or less but this could go up to 3 per cent for private banks. Most of the banks,whether private or public,have prepayment clauses which are different for different stages of loan. For example,if a loan has been taken for 20 years and the borrower wants to prepay it after paying just 24 EMIs,the bank may charge heavy prepayment penalty. However,if the borrower has paid 120 EMIs and wants to prepay,the penalty could be less. Borrowers should time their refinancing option so that they have to pay least penalty.

Loan processing charges by the new bank: Borrowers should also take processing charges as one of the cost factors of loan. A high loan processing charge can make the new loan expensive.

Your income and expenses: Many borrowers,in their rush to pay the loan as soon as possible,refinance their home loan for shorter tenure by increasing their EMI. This can hurt the borrower in his or her personal life. Borrowers should ensure that their total outflow should not exceed 50 per cent of their income. If the tenure has to be longer,so be it.

Here is an example to help you decide

Suppose home loan borrower Rakesh has an outstanding loan amount of Rs 20 lakh for the next 10 years. Rakesh is paying an interest rate of 12.5 per cent. The EMI is Rs 29,275.

Rakesh gets a refinancing offer from another bank with interest rate of 11.5 per cent. The EMI at this rate will come about Rs 28,119. (See table)

Rakesh,like most of the borrowers looks at the interest outflow in two cases that comes to about Rs 15,13,000 in case 1 and Rs 13,74,280 in case 2.

This means a saving of 1,38,720 over 10 years and most of the borrowers would like to go for it.

However,Rakesh has not taken into account the prepayment penalty that he will have to pay to the existing bank. In addition to prepayment penalty,Rakesh will have to pay processing fee to the new bank.

Suppose the prepayment penalty charged by the existing bank is 2 per cent and processing fee for refinancing is 0.5 per cent. Now taking these extra expenses into account,the total outflow in case 2 will be the following:

Prepayment penalty = Rs 40,000

Processing fee = Rs 10,000

Total outflow over 10 years = Rs 34,24,280

If you factor these charges,the saving comes down to Rs 88,720 over a period of 10 years. If you take the present value of this savings,it will be very low as is seen in the table.

The question is should Rakesh take go through the entire exercise of filling up forms,doing his due diligence,have the property paperwork done afresh and spending time on this to save such a meagre amount over a period of 10 years? The answer will differ from person to person.

Lately,the Reserve Bank of India (RBI) and the National Housing Bank (NHB) have shown concern on prepayment penalty and has been opposing it for quite a long time. Earlier banks were reluctant to comply with RBI’s insistence on removing prepayment penalty but now the response by banks is encouraging. Some like SBI and Axis Bank have already done away with it while HDFC does not charge prepayment penalty if the borrower repays with funds from own sources. All signs indicate that we can expect the prepayment penalty to become non-existent in the near future,at least for floating rate home loan borrowers.

Refinancing your loan when the interest rates are in a downward trend will be a good move as it will not make sense if the bank you are shifting to ends up raising their interest rates in a matter of months after the loan transfer.

Borrowers,however,must do the cost benefit analysis to find out if refinancing saves a good amount of money.

— Author is CEO,

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