How Profitable is Refinancing your Old Loan
Interest rates on loans, especially housing loans, have been continuously sliding in the last two years. In such a situation, borrowers who had contracted long-term housing loans some years ago at floating rates of interest have benefited, as they have gained from the lowering of rates due to changes in the benchmark rates to which it is linked.
Fixed interest rate borrowers now face a dilemma — whether to continue to repay the remaining portion of the loan at higher rates or swap the existing loan with a cheaper loan. On the face of it, every borrower would like to opt for the latter, but take a peek into the finer points — and there’s some thinking to do.
First, let us understand the difference between fixed and floating rate of interest. The fixed interest rate is a rate not linked to market conditions. It remains the same irrespective of movements of interest rates in the market. Many lenders set the fixed interest rate few basis points higher than floating interest rate. Such a rate is beneficial when the interest rates in the market are on an upward trend.
In the case of floating rates, the interest rates are linked to a benchmark rate. As and when the benchmark rate moves, the interest rate would be adjusted to reflect the change. So if market rates fall, the benchmark rate would fall and the borrower will pay lower interest and vice versa.
But you must remember to track the movement of the floating rate in line with the benchmark rate to see the period after which and the extent to which the lender passes on the benefits of fall in rates.
Having seen the difference between fixed and floating rate, it becomes evident that in a scenario of falling interest rates, if you have borrowed at a fixed interest rate, you will stand to lose, as you will not be able to take advantage of the lower interest rates. In such a case, there are two things you can do.
One would be to convert your fixed interest loan into a floating interest loan by taking another loan at a floating rate to repay the original loan. But there is a danger in doing this. If interest rates start to shoot up, you will end up paying a higher interest and might end up paying more than what you would have paid had you decided not to swap.
And since housing loans are usually spread over a very long period of time, there are possibilities of this happening. The second option is to borrow at a lower rate of fixed interest to repay the original loan. But before you decide to do so, there are some important points that you should bear in mind.
If the balance term for repayment of the old loan is not very long, it will not be wise to go in for a loan swap. Firstly, the savings in interest when the balance repayment term is short will be very less and secondly, the prepayment and processing costs incurred in the process are levied at a flat rate, irrespective of balance term for repayment.
Almost all lenders levy a prepayment charge in case you want to pay off your entire loan before the due date. This is because, the lender plans his finances assuming you will repay over a specific time and when you decide to prepay, he will have to re-align his position to maintain the balance.
Further, a processing charge is levied to take care of documentation and process involved for the new loan. So, the savings by way of interest would be eaten up by the prepayment and processing costs, giving you no benefit from the swap at all.
For example, you have taken a loan of Rs 10 lakh for a period of 20 years at an interest rate of 11%. Now, at the end of 15 years suppose the interest rate falls to 9%, by going in for a loan swap, you will save on interest for 5 years but you might also pay 2% prepayment charge and 2% processing charge. The charges that you pay may not justify the interest savings of five years. However, instead of a rate cut at the end of 15 years, if the same were to happen at the end of 10 years, the scenario would be quite different.
You would save interest on the balance term of 10 years, which would be quite substantial and would sufficiently cover the additional charges involved.
The next thing to remember, is that you should keep the term on the second loan equal to or less than the balance repayment term of the original loan. Longer the term, more will be the interest liability, even though the equated monthly installment may be smaller that your older EMI.
If you are contemplating a switch, make sure that there is substantial change in the interest rate. If the interest rate has dropped only by about 0.25%, it may not make sense to go through the process when you might end up saving only a tiny amount.
Moreover, the process of loan swapping can sometimes be quite tedious with respect to the documentation involved. Ask your banker what exactly the documentation and time duration for the process would be. More On http://freesticky.bravehost.com
Fixed interest rate borrowers now face a dilemma — whether to continue to repay the remaining portion of the loan at higher rates or swap the existing loan with a cheaper loan. On the face of it, every borrower would like to opt for the latter, but take a peek into the finer points — and there’s some thinking to do.
First, let us understand the difference between fixed and floating rate of interest. The fixed interest rate is a rate not linked to market conditions. It remains the same irrespective of movements of interest rates in the market. Many lenders set the fixed interest rate few basis points higher than floating interest rate. Such a rate is beneficial when the interest rates in the market are on an upward trend.
In the case of floating rates, the interest rates are linked to a benchmark rate. As and when the benchmark rate moves, the interest rate would be adjusted to reflect the change. So if market rates fall, the benchmark rate would fall and the borrower will pay lower interest and vice versa.
But you must remember to track the movement of the floating rate in line with the benchmark rate to see the period after which and the extent to which the lender passes on the benefits of fall in rates.
Having seen the difference between fixed and floating rate, it becomes evident that in a scenario of falling interest rates, if you have borrowed at a fixed interest rate, you will stand to lose, as you will not be able to take advantage of the lower interest rates. In such a case, there are two things you can do.
One would be to convert your fixed interest loan into a floating interest loan by taking another loan at a floating rate to repay the original loan. But there is a danger in doing this. If interest rates start to shoot up, you will end up paying a higher interest and might end up paying more than what you would have paid had you decided not to swap.
And since housing loans are usually spread over a very long period of time, there are possibilities of this happening. The second option is to borrow at a lower rate of fixed interest to repay the original loan. But before you decide to do so, there are some important points that you should bear in mind.
If the balance term for repayment of the old loan is not very long, it will not be wise to go in for a loan swap. Firstly, the savings in interest when the balance repayment term is short will be very less and secondly, the prepayment and processing costs incurred in the process are levied at a flat rate, irrespective of balance term for repayment.
Almost all lenders levy a prepayment charge in case you want to pay off your entire loan before the due date. This is because, the lender plans his finances assuming you will repay over a specific time and when you decide to prepay, he will have to re-align his position to maintain the balance.
Further, a processing charge is levied to take care of documentation and process involved for the new loan. So, the savings by way of interest would be eaten up by the prepayment and processing costs, giving you no benefit from the swap at all.
For example, you have taken a loan of Rs 10 lakh for a period of 20 years at an interest rate of 11%. Now, at the end of 15 years suppose the interest rate falls to 9%, by going in for a loan swap, you will save on interest for 5 years but you might also pay 2% prepayment charge and 2% processing charge. The charges that you pay may not justify the interest savings of five years. However, instead of a rate cut at the end of 15 years, if the same were to happen at the end of 10 years, the scenario would be quite different.
You would save interest on the balance term of 10 years, which would be quite substantial and would sufficiently cover the additional charges involved.
The next thing to remember, is that you should keep the term on the second loan equal to or less than the balance repayment term of the original loan. Longer the term, more will be the interest liability, even though the equated monthly installment may be smaller that your older EMI.
If you are contemplating a switch, make sure that there is substantial change in the interest rate. If the interest rate has dropped only by about 0.25%, it may not make sense to go through the process when you might end up saving only a tiny amount.
Moreover, the process of loan swapping can sometimes be quite tedious with respect to the documentation involved. Ask your banker what exactly the documentation and time duration for the process would be. More On http://freesticky.bravehost.com
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