How RBI raising Rates Affects your home loans ?

For the common man, a repo rate hike means bank deposits will earn a marginally higher interest while the interest rate on loans will also rise.

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The Monetary Policy Committee of the RBI raised the policy rate by 25 basis points on Wednesday and the repo rate currently stands at 6.50 per cent. This increase in repo rate will increase the cost of funds, and therefore lead to a rise in the MCLR (marginal cost of funds based lending rate), which banks adhere to while setting interest rates on loans.

For the common man, a repo rate hike means bank deposits will earn a marginally higher interest while the interest rate on loans will also rise. Let’s take a deeper look at the impact on loans and FDs, and what the repo rate hike means for the borrowers and investors.

How the RBI rate hike impacts FDs

With the increase in policy rates, the interest offered on FDs (fixed deposits) is likely to increase. In fact, State Bank of India had already upped its deposit rates by 5 to 10 bps a day before the RBI’s announcement. This increase is marginal and doesn’t call for any dramatic shift in your fund allocation.

You require FDs to maintain liquidity for your near-term money needs. However, it would be unwise to lock a lot of money into FDs, even with the rising interest rates. Interest rates rise in response to the rising inflation rate, therefore a marginal increase in the deposit rate may be inadequate from a returns point of view, since the value of money has also decreased.

For example, if your FD rate is 6.5 per cent while the inflation rate is 5 per cent, the true value of your returns is just 1.5 per cent, which is further diminished by the tax you may have to pay on your interest earnings. In this scenario, liquid or short-term mutual funds may be a better bet for conservative investors looking for capital safety, and moderate returns.

While the returns from these funds may be comparable to FDs, mutual funds are much more tax-efficient than FDs because you’re taxed only when you redeem your investment. If your debt mutual fund investment is held for a period of three years or longer, you pay Long Term Capital Gains at 20.6 per cent with indexation benefits, which substantially reduces your tax burden if you are in the top tax slab.

Impact of rate hike on home loans

The hike in repo rate will have an impact on home loan EMIs. Considering banks’ MCLR will go up, the interest on loans will also go up.

As per the RBI mandate, all bank loans disbursed post April 1, 2016 are MCLR-linked and the lending rate cannot be below the MCLR rate. Over the last two monetary policy committee meetings, the repo rate has gone up by a total of 50 bps and here is how it could impact your loan EMI:

Say, you had started off with a loan of Rs. 30 lakh in January 2017 at 8.5 per cent stretched over 20 years. Your EMI is Rs. 26,034 and the total interest payable in 20 years is Rs. 32,48,327.

Now if the interest rate rises to 9 per cent, your new EMI will be Rs. 26,939, which is almost Rs 1,000 more every month and your total interest payable will be Rs. 34,48,383. This interest payment is Rs. 2 lakh higher than the original plan.

What should a borrower do

Firstly, if you are still contemplating taking a home loan, you shouldn’t wait any longer as banks are soon going to start increasing the interest rates. Your future EMIs will be calculated based on the MCLR effective on that date for the bank. If you are an existing borrower, your EMI burden is likely to increase once the new MCLR rate comes into effect. For loans taken from NBFCs, and Housing Finance Corporates interest rates will rise similarly.

Irrespective of whether you are a new or existing borrower, consider pre-paying a part of your loan repayment amount. Use any surplus money you have in hand to do so. It could be your annual bonus, salary increment or a cash gift. Pre-payment of your loan will reduce your interest outgo.

How does pre-payment of loans help?

So, if you look at the example mentioned earlier, your outstanding loan balance after consistent payment of EMI for the last 19 months is Rs  29,03,055. If you make a pre-payment of Rs 1 lakh at this juncture, your pending interest payable will reduce to Rs. 26,65,402. This will save you an interest outgo of Rs. 3,85,266 in the long run.

Your loan tenure will reduce to 203 months from 221 months. These are substantial long-term savings. The pre-payment will also cushion you against the impact of future rate hikes.

However, if you are nearing the closure of the loan and do not want to reduce the loan tenure in order to continue availing tax benefits, you can reduce the quantum of EMI and stretch it over a longer period. You can also consider the option of moving your home loan from one to bank to another after comparing the rates.

However, you might want to weigh the cost of making a transfer and the processing cost against what you will benefit from it.

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