Repo rate hike & impact on borrowers

The Reserve Bank of India (RBI) has finally bitten the bullet and taken the hard step of hiking the repo rate in the first quarter of the new financial year after many soft steps which probably were not sufficient to curtail the monster of inflation.

With the increase of interest on savings account and rise in repo rates (rate at which the RBI lends to the banks) by the RBI, the banks are now left with no alternative but to raise the interest rates on all loan products because of this double whammy.  

Till now, banks have resisted the temptation to raise their interest rates with every rise in repo rates, but not any more. Many prominent players have already increased the interest rates between 0.50 and 0.75 per cent depending on the leeway the bank has and the competitive scenario.

Impact on borrowers

Due to the current rate hike, the worst affected are home loan borrowers who are servicing the loan under floating interest rate as the lenders have the power to increase the rates of interest on the basis of its base rate for their floating rates.

Another reason for home loan borrowers to be hard hit by this rate hike is the fact that the amount generally borrowed as home loan is substantial and the repayment tenure is also very long. Those of you who have borrowed home loans under floating rate options, will have to pay higher interest rates on the amount outstanding as your bank is bound to take the inevitable step of increasing the interest rates.

Options with customers and banks

This increase in interest rates impacts your EMI in two ways. In the direct way, your bank will increase the amount of EMI and in that case, you will have to shell out more money every month to service the existing home loan. This option of raising the amount of EMI may or may not be feasible for many borrowers. The other option is that of the bank ensuring that the amount of your EMI is the same, but increasing the number of EMIs which you will have to pay by extending your loan tenure. But this is not that simple to implement as increasing number of EMIs.

This may impact many borrowers heavily. Moreover, the bank will not exercise this option if you are nearing the retirement age of 60 years. Therefore, you will invariably have to service the increased EMIs because of increase in interest rates. But if you have substantial number of years left to retire, then the bank may offer you this option.  

If you want to avoid both these situations, consider making part pre-payment of your outstanding loan amount which ensures that the amount of EMI and the number of EMIs remains the same. But you should consider this only if you have your own surplus funds which you may not need in the immediate future. It will not be a wise step on your part if you borrow (read from other lender) from somewhere else to part pre-pay the loan to keep the amount and number of EMIs same because then you will end up paying an additional EMI for this new loan.

Generally, the loan amount of home loan is quite significant and it is not always possible to arrange for such huge funds to pre-pay the full loan amount. But, if you are contemplating repayment of the full outstanding amount, you need to ponder over a few points.

Implication of full repayment

As the home loan tenure undergoes many interest rate cycles, fluctuating interest rates are part of the deal. Therefore unless you own  sufficient funds to spare, which you may not need in the near future, you should not consider the option of pre-payment. Before taking this step, you should evaluate other options where the surplus money can be invested.

As the home loan comes with relatively lower rate of interest, the net effective interest rate goes down due to tax deductibility of interest. If the effective rate of return on alternative investment is expected to be more than the effective rate of interest on home loan, it does not make sense for you to prepay the home loan.

Moreover retaining the surplus money invested in alternative avenues will give you a financial buffer in case you need money in future for any financial emergency. Particularly, if you are considering full repayment, then remember the other implications of interest rate cycle like pre-payment penalty charged by the bank in accordance with your loan agreement. Another implication is that the tax breaks which you are availing would no longer be available once the entire home loan is repaid.

As per income tax laws, presently you are able to claim income tax benefits in respect of interest payment and principal repayment. So the effective rate of your home loan is substantially lower than what you are actually paying.  

Once you pre-pay the entire home loan, your tax liability to the extent of interest benefits will go up. As far as principal repayment component is concerned, you will anyway be able to claim the full amount of Rs one lakh for the current year ending on March 31, 2012. This will not have any effect in future years as the Direct Tax Code which is proposed to be implemented from April 1, 2012, does not have any provision for allowance of tax benefits in respect of loan repayment.

If you are anticipating requirement in future for which you would have to borrow, please keep in mind that all borrowings other than home loan are costlier.  So before you decide to take a particular decision on repayment of your home loan, please evaluate all the pros and cons before going in favour of any particular decision.