The long awaited cut in rates finally happened in the April 17th RBI policy review when the central bank cuts it CRR by 50 bps to bring it down to 8%. From a very harrowing hike spree last year that lead to nearly 13 rate hikes in 18 months the situation became stable only in the last couple of months. With such a large number of hikes last year a downward trend in lending rates offered by banks is expected to be imminent this year, if not immediately a few months down the line and this RBI move would be just the right trigger for that to happen!
Impact on Borrowers
Existing borrowers are usually the biggest victims when interest rates rise or fall; they usually bear the brunt of rising interest rates but lose out on benefiting from the downward trend! If lending rates alone are slashed, existing borrowers after facing steep rate hikes last year will still face no respite. The delta or spread at which the new borrower obtains their loan with interest rates being slashed will be lower compared to the spread at which an existing borrower took his loan. This means if interest rates rise again later during the loan tenure, new borrowers still stand to gain! However, if base rate falls eventually both existing borrowers and new borrowers will benefit.
Let’s look at what new and existing borrowers can do in the current scenario to mitigate any adverse effect.
New borrowers – Wait for clarity in interest rates
New borrowers who plan to avail loans should postpone their decision till they feel interest rates are on an affordable platform for them. Do not forget the fundamentals. You have to ensure your loan to income ratio is less than 40%.
Existing borrowers – Check for loan conversion options
In such circumstances to either decrease your EMI burden or shorten the loan tenure – as the case maybe you can try to discuss the situation with the bank to arrive at a mutually beneficial solution. Though banks or HFCs do not offer the option of negotiating interest rates half way through one’s loan tenure, some banks and housing finance companies do consider a request from a borrower who has a good repayment track record.
On the basis of such a request, sometimes a loan conversion scheme could be worked out by the bank where the bank can shift an existing borrower to a new loan rate that a new borrower can lay claim to! In any case banks are expected to be involved in such an exercise when the base rate regime was introduced, where the old borrower can request to shift to the base rate system of interest rates.
Let us consider an example of how this works: Manoj took a loan from a housing finance company in November, 2008. After factoring in all his hikes he is currently paying a loan interest rate of 14% on his current outstanding loan amount. He approaches his housing finance company in an effort to negotiate his home loan interest rate as he finds that the new borrower is able to take up a loan at a much lesser interest rate than he is currently paying. On the basis of the good repayment track record the bank agrees to consider his request especially since he would always have the option of a loan transfer to a different bank.
However, to avail a new interest rate he would need to pay an upfront amount as a loan conversion fee. Banks usually charge a percentage of your outstanding principal amount as the conversion fee. The minimum percentage of your outstanding principal amount that is usually charged as fee is 0.5% -1%. The higher the spread between the new interest rate and the old interest rate, the higher the conversion fee that needs to be paid to the bank.
In case of a significant difference in spread, banks also calculate it in the following manner – By charging the consumer one half of the spread percentage of the outstanding principal amount.
Let us understand how much Manoj paid as loan conversion fee:
He took a loan of 30L on November 1, 2008 for loan tenure of 20 years at an interest rate of 11.75%. His current interest rate is at 14% and outstanding loan amount is Rs.28 L.
Let’s say the new interest rate he converts to in May 2012, is 10%. The difference in spread between the two interest rates is 4%.
The percentage at which his loan conversion fee will be calculated on his current outstanding loan amount is ½ of 4% which is 2%.
Loan conversion fee =2% of 28 L = Rs.56,000
You can do this even periodically to bring down your loan tenure considerably as the reverse happens (Increase in interest rate, will lead to increase in tenure, while if you move to a lower interest rate your tenure will decrease with the EMI being constant – i.e. same as when you started your loan). Of course you need to factor in the conversion fee and figure if it will still be beneficial. Chances are it will prove beneficial, helping you close out your loan earlier than planned.
Another way to do this conventionally is of course prepay your loan amount. Banks may have a clause stating you should not prepay immediately after you convert a loan. This may vary anywhere between 3- 6 months depending on the bank.
However, a combination of prepayment and conversion can yield good results. If your bank is not amiable to a loan conversion you should try prepaying in small amounts regularly instead. This is a conventional option to close out your loan early.