Switching Home Loan? Do Your Calculations

If rising interest rates on loan EMIs was not enough to send your overall monthly finances for a toss, inflation numbers for recent months (July @ 9.22 per cent) are in line with market expectations of another rate hike in RBI’s next monetary policy announcement on 16 September. In such testing times when EMI burden becomes too heavy, one should look to negotiate with bank for restructuring or else for options of switching the loan to another bank at lower interest rate.       

Making Switch

The Home loan switching or balance transfer is an option, wherein you transfer your home loan to a bank with lower interest rates. The option is always at your disposal due to difference in interest rates of various banks. The difference in the interest rates of banks arises due to their individual assets-liability situation. The option makes more sense for those who would have taken home loans prior to 2008 and till date would have seen their floating rates go up by 3-4%.

The Calculations

While a balance transfer certainly reduces your EMI outgo, there is still no standard solution for everybody. To judge the viability of switching option for you, one needs to decipher its cost-benefit analysis with figures before signing the dotted lines with the new lender. Two things, really imperative for any home loan switcher are:

a) Difference between the interest rate

b) Tenure remaining for your original loan  

Switching Your Home Loan: Facts

The underline hypothesis here is that larger the difference in interest rates, maximum would be the savings in EMIs, with maximum tenure. Also, we know that in earlier years, EMI constitutes maximum portion of interest component, and hence earlier you decide to pay, more interest you avoid paying and that too at a higher rate.

Here, as a thumb rule, one should go for switching in the loans, only if the difference in interest rates is at least 1.5-2 per cent, with remaining loan tenure of around 8-10 years.

Cost Benefit Analysis

In addition, another reason for choosing the maximum interest rate differential is the charges involved in a loan switch. It includes pre-payment penalty as well as switching charge/ foreclosure charge of existing loan and processing fee charged by new lender. Typically, the existing bank charges pre-payment penalty ranging 1-2% of the total outstanding principal amount, whereas processing fees generally ranges between 0.5-1% of total loan amount.

Cost-Benefit Analysis

In our example, Ms. Charu took home loan worth Rs 30 lakh for 20 years with South Indian Bank in 2008 and paid first installment worth Rs 38,731 on August 1, 2008. After paying installments for 3 years, wherein interest rates for her have gone up to 14.65 per cent, she explores an option to home loan switch with SBI, at much attractive rate of 11.75 per cent (present rate for loan below Rs 30 lakh). However, she will have to bear Rs 10,000 as processing fee with SBI and pre-payment penalty to the extent of 2% with South Indian Bank. As on 1^st September, 2011, her total principal outstanding is Rs 29.05 lakh.

In this case, the net savings after accounting the pre-payment and processing fee collectively worth Rs 68,110.82 (Rs 58,110.8 + Rs 10,000) would come out to be Rs 14.95 lakh, considering EMIs of over 17 years (Rs 7,666*204), which is very significant and validate the home loan switching.

In case, if you are fed up of paying higher EMIs and want to look for options, you can also consider the interest rate regime change – from fixed to floating or floating to fixed – if you find it to be cost-effective, as per calculations. In this case, you would not have to pay pre-payment or foreclosure charges; however, switching charge would still be applicable but different. The fixed and floating rates of some major banks are given below:

Fixed vs Floating Rates

Conclusion

Your eventual decision of switch mush be based on the calculations as cost-effectiveness may differ with the change in amount, tenure left, and difference in interest rate.