In the last six months, the Reserve Bank of India (RBI) has hiked both its repo and reverse repo rates by as much as 100 basis points each—repo rates have gone up from 6.25% to 7.25% and reverse repo rates are at 6.25%, up from 5.25%. Banks borrow from RBI at the repo rate and deposit with RBI at the reverse repo rate.
For banks, this means increase in cost of funds and for you, increase in their cost of loans since banks have been quick to pass on the extra burden to their customers.
You can shoulder this burden in two ways—by settling for an increase in the loan tenor by increasing the equated monthly instalments (EMIs).
But which option would make more sense. While on the face of it, increasing the tenor seems to be more cost-effective, it is not actually so. We ran numbers and found out that keeping inflation and tax constant, it makes more sense to increase the EMI in the long run. Increasing the tenor does not increase your immediate expenses, but is costlier in the long run since the total cost of loan, including the interest outgo, increases in this case (see graph).
Increasing the EMI
If you can afford higher EMIs, we recommend you do so because this option is cheaper in the long run. Sample this: you have a loan of Rs 30 lakh at 9% for 15 years; you service the EMIs for six months and then the interest goes up by 1%. If you agree to increase your EMIs, your total cost of loan (principal plus total interest outgo) will go up to around Rs 57.84 lakh from around Rs 54.77 lakh at the earlier rate. But if you choose to increase the tenor to around 17.08 years (including initial six months) instead, your total cost of loan would notch up to around Rs 62.39 lakh. In the same example, if the rate increase is 2%, the cost of loan goes up to around Rs 60.99 lakh if the EMI is increased and around Rs 75.17 lakh if the tenor is increased to 20.58 years (including initial six months).
Says Vipul Patel, director, Home Loan Advisors, an independent mortgage advisory firm, “If the customer can afford it, paying higher EMI is a better option than increasing the tenor on the loan. If the tenor is increased the total cost of the loan grows by a huge amount as compared with when EMI is increased.”
However, increasing the EMI comes with a hassle for both banks as well as borrowers due to administrative and operational reasons.
“When the EMI is increased the customer has to give fresh post-dated cheques (PDCs) or set a new ECS (electronic clearing system) amount,” says R.K. Bansal, executive director, IDBI Bank Ltd.
Increasing the tenor
Banks usually prefer increasing the tenor. While doing this is operationally smooth, it also ensures that banks earn more.
If the tenor is increased and EMI is kept the same, you won’t have to issue fresh PDCs or issue a new ECS mandate.
However, if you think increasing your EMIs would mean a severe cash crunch in your monthly household budget, you may want to settle for increase in tenor despite the cost bite. But keep in mind that banks do not extend the loan tenor beyond your retirement age. “The increase in tenor is never beyond the age of 60-65 years of the borrower and also depends on the income,” says Bansal.
There are times when increasing the tenor is not possible and you may have to choose to increase the EMI as well as the tenor.
What else can you do
Switching the lender: If another bank charges a lower rate then it makes sense to switch the loan to that bank, but before doing that you need to keep certain things in mind.
Says Adhil Shetty, CEO, Bankbazaar.com, an online loan portal, “If you plan to switch the loan, don’t just look at lower interest rates. Take into account the pre-payment penalty of the current loan and the processing fees of the new lender. Only if the total cost of loan is lower than your total cost of the current loan would it makes sense to switch.”
Online calculators can help you get the numbers.
Part-payment: If you have the funds, regularly part-pay the principal over and above the EMI. If you can make a lump sum part-payment, even better. Says Patel, “The part payment goes towards the principal amount of your loan. Here, since your principal outstanding amount reduces, even the interest amount you need to pay will reduce. In fact, even as you start part-prepaying the loan, your tenor of the loan will also reduce.”
However, do check with your bank if they charge any part payment fee.
All in all, increasing the tenor would be the most costly for you; opt for it only if you really need to.
Graphic By Ahmed Raza Khan; Illustration By Jayachandran