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Why Switching Your Home Loan May Not Be a Good Idea   Nov 15, 2018


'If something feels too good to be true, it probably is,' holds true for naïve home loan borrowers who fall for the 'lower interest rate' trap set up by banks.

Let me explain.

The interest you pay on home loans is directly linked to the RBI's Repo rate. In simple terms, this repo rate is the rate at which the central bank (Reserve Bank of India) lends money to other banks.

A hike in the repo rate means that your bank/s pays a higher interest rate to RBI on their borrowings and will, therefore, charge you a higher interest rate on the amount you borrow.

[Read more: 11 Hidden Costs associated with your home loan]

Whenever the RBI raises the repo rate, the banks increase the interest rate on your home loan and you end up paying higher EMIs.

A higher interest rate essentially means that you will get increased calls, messages, and emails from various lending banks offering to transfer your home loan from your current lender and save up to 0.50% - 1% on your EMIs. Their pitch usually includes saving in lakhs in EMIs and how that money can be invested in different funds and earn higher returns, etc.

Now while the offer might seem tempting, remember there's always a catch.

In the following case study, let's analyse why transferring your home loan/s to another lender to save 0.50% - 1% interest on EMIs might not be beneficial at all.

The other day our financial planning client casually remarked that a bank was offering him a home loan at 8.75% p.a. His existing home loan rate was 9.25% p.a. and he was considering a switch, thereby saving 0.50% p.a. for the next 16 years. This would be equivalent to saving Lakhs, which he would then invest in Mutual Funds and create wealth.

He wanted my opinion on his strategy.

The strategy seemed good, but he was in for a rude shock. That's because, while 0.50% p.a. savings for the next 16 years would indeed amount to a decent corpus, the benefit of 0.50% p.a. would wilt away through the processing fees that banks charge while approving loans!

Yes, the banks are smarter than customers and there is no way that they will incur losses while we make profits.

Here's how the whole home-loan switch works:

Assuming Mr Ram bought a home loan of Rs 50 Lakhs in 2015 at 9.25% p.a. rate of interest for a 20-year time horizon, his EMI works out to be Rs 45,793 and the total interest that he will end up paying throughout the tenure is Rs. 59.90 Lakhs, in addition to the principal repayment of Rs. 50 Lakhs.

Table 1: Existing home loan calculation
 
Particulars Amount
Loan Amount        50,00,000
Tenure  20 years
Interest rate 9.25%
EMI              45,793
Total Interest paid throughout the tenure         59,90,402
Total Principal repaid        50,00,000

               According to the calculation by the sales department of the bank offering him 8.75% p.a. rate of interest, his fresh home loan amortisation table would be as below:
Table 2: Home loan switching calculations
 
Particulars Amount
Loan Amount 45,91,125
Tenure  16 years
Interest rate 8.75%
EMI 44,297
Total Interest paid throughout the tenure          40,02,675
Total Principal repaid 45,91,125

Since Mr Ram had already paid 46 months EMI at 9.25%, his new loan amount was reduced to Rs. 45.91 Lakhs, which at 8.75% p.a. for remaining tenure equalled an EMI of Rs. 44,297.

To a common man paying 59.90 Lakhs earlier and paying 40.02 Lakhs now as interest means a savings of Rs. 19.87 lakhs, but in reality, his savings are only 2.79 Lakhs.

This is how loan companies trick us. Keep in mind that if you have already repaid the loan for four years out of the 20-year tenure, while switching to a new loan, you need to calculate your loan interest from 16-0 years and not 20-0 years.

Table 3: Interest comparison
 
Particulars Amount
Total interest payable for remaining tenure - old loan  42,82,460
Total interest payable for remaining tenure - New loan  40,02,675
Savings in hand     2,79,785

As you can see according to this calculation, the real savings is only Rs 2.79 lakhs.

But wait, there's another catch!

If Rs 2.79 Lakhs is the savings for 16 years, then the present value of Rs 2.79 Lakhs discounted today will be Rs 73,107. Yes, all this shuffle is worth is Rs 73,107, off which you will end up paying Rs22,956 as the processing fees, and so your net gain is Rs 50,151.

Yes, you will not save Rs 19.87 lakhs, or Rs 2.79 lakhs, or even Rs 73,107.

In fact, it's Rs 50,151!!!

So, do we mean that one should never switch home loans however attractive the yield? Not entirely, but the below pointers should be kept in mind before you make a switch…

  1. Ensure that there is more than 1% spread in interest rate of old home loan and new loan. Anything below 1% spread and there is no real gain in switching.
     
  2. Ensure that the processing fees is not more than 0.50% as anything above will reduce your gains further.
     
  3. Ensure that you switch early in the loan tenure, i.e. if the loan is for 20 years, a switch should be made in the starting 5-7 years; the closer you get to the end date, the more you will lose out on gains.
Remember the next time you get a call offering you lakhs in savings by switching home loans, you know what to do.  

While it is not possible for a common individual to understand the nuances of such decisions, a certified financial planner is adept in ensuring that you don't fall in such interest rate traps and will also ensure that your home loan decisions are made keeping in mind your financial goals.

To ensure you make smart decisions, get in touch with PersonalFN's financial guardian on 022-61361200 or write to info@personalfn.com. You may also fill in this form, and soon our experienced financial planners will reach out to you.

Author: Deepika Khude



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