ATM :: Refinancing home loans can save on total outgo

By Sangeetha G. | Apr 25 2014 | Chennai |
Lower interest rate, shorter tenure or shifting a loan from fixed to floating rate or vice versa are the key benefits of this option


Once a home loan is taken from a bank or a housing finance company, it need not bind the borrower to that bank or company for the entire tenure of the loan. There is the option of refinancing of home loan — an option worth exploring by the borrower.

Refinancing involves replacing an older loan with new one with better terms. In case of home loans, one resorts to refinancing for different reasons, but the goal is to lower the total outgo in the long term.

The benefit could be paying a lower interest rate, a shorter tenure or shifting the loan from a fixed to floating rate or vice versa.

“The cost and pain of shifting a loan to a different institution has to be considered while going for refinancing. The cost-benefit analysis has to be done properly before taking up the exercise,” said Suresh Sada­gopan, founder, Ladder7 Financial Advisories.

Even if an existing loan does not have pre-payment penalty, there will be a one-time cost of processing charge for the new loan. This can be around 0.5 per cent and usually there is a cap of Rs 25,000 on the processing fee. Some banks also waive this processing fee for people with high credit score.

By and large, borrowers opt for refinancing when the interest rates are coming down. Or in cases when the bank is hiking interest rates more frequently than others, they might consider shifting the loan to another bank or financial institution.

It makes sense to close an existing loan with a new one when there is an interest rate differential of at least 0.75 or 1 per cent.

Take the case of a home loan of Rs 25 lakh with an interest rate of 11.5 per cent and a tenure of 20 years. Paying an equated monthly instalment (EMI) of Rs 26,661, the home loan customer will be shelling out Rs 39 lakh as interest and Rs 64 lakh in total at the end of 20 years. If she opts to move the loan to a lower interest rate of 10.5 per cent, she will have to pay an EMI of Rs 24,959 and end up paying a total interest of Rs 34.90 lakh in 20 years. The total outgo will be Rs 59.90 lakh in these years. Thus she will be saving over Rs 4 lakh on the total outgo.

The monthly savings on the EMI can go into systematic investments in mutual funds or exchange-traded funds, thus helping in creating wealth in the long-term.

“There are investors who book their profits from equities, when they are high. These profits are used while closing the existing loan and going for refinancing to bring down the principal amount. The monthly savings on the lower EMI can go into the SIPs of mutual funds,” said Sadagopan.

When interest rates go down, banks usually lower the rates for new loans. Some banks also allow the customers to close their older loans and go for a new one to take advantage of the new rate.

Refinancing is also opted for when one wants to bring down the tenure of the loan in order to lower the total outgo on the loan. In case one gets a salary hike, he can opt for refinancing the loan to close it early. A slight increase in the EMI can save much in the long term.

Once again let us take the case of the person who has a Rs 20 lakh loan at 10.5 per cent interest rate for 20 years. If she brings down the tenure to 15 years by going for refinancing, the EMI will go up to Rs 27,635, an increase of Rs 2,676 per month. In the second scenario, she will have to pay an interest of Rs 24.74 lakh at the end of 15 years and the total outgo will be Rs 49.74 lakh. At the higher monthly installment, she will be paying Rs 4.8 lakh more. But at the end of the tenure, she would have saved more than Rs 5 lakh.

Usually customers opt to pay a higher EMI on the existing loan itself to bring down the tenure. But if there is an added advantage of lower interest rate, shifting the loan account to a different bank or financial institution increases the savings.

Refinancing can also be an option when one wants to change a loan from fixed to floating interest rate and vice versa.

Nowadays, the bulk of home loans are under floating rates. Unlike floating rates, closing a fixed rate loan invites prepayment penalty in most cases. Those who had taken loans on fixed rates might reconsider their decision when interest rates are on a slide. In such cases, the cost-benefit analysis should take care of the prepayment penalty as well.

Fixed rate loan is not very popular these days. But a committee of the Reserve Bank of India is looking into encouraging fixed rate home loans by relaxing pre-payment penalty and reducing the differential between floating and fixed rates.

Customers who are disappointed by banks hiking rates frequently on one hand and not passing on the benefit when the RBI softens rates, would possibly think of moving into fixed rates. In such cases also, replacing the old loan with a new one can be an option.

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