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In response to rate cuts by the RBI, banks have reduced their base rate by 25 basis points (100 basis points = 1 percentage point). This is good news for borrowers. Since floating rate loans such as home loans are linked to the base rate, the EMIs (Equated Monthly Instalments) will decline.
New borrowers
While this should bring some cheer to the existing borrowers, it is the new borrowers who walk away with the cake. Take the case of State Bank of India. While existing home loan borrowers (less than Rs 30 lakh loan) have only 25 basis points relief, the new borrowers get an additional cut of 25 basis points. This is because, in August, SBI and few other public sector banks cut the spread between home loan rate and base rate only for new home borrowers. Additionally, a portion of the processing charges are also cut now in order to stimulate home loan borrowing. Let us understand how this impacts the EMIs with a simple example.
Say you took a loan for Rs 1 lakh for 5 years from SBI early this year. You would be paying Rs 2,150 as EMI. Now, you will pay Rs 2,137 a month after the 25 basis point cut. Considering a Rs 30 lakh loan, it lowers the outgo by Rs 390 a month. In contrast, a new home borrower gets a 50 basis point cut and his EMI will be still lower at Rs 2,124 a month.
Choice to switch
Existing borrowers have the choice to switch to banks where they can now incur lower EMIs as there are no prepayment charges. A smart borrower can make use of nil-prepayment and low processing charges on new loans (festival season offer) to shift loan to a different bank and further reduce EMI.
But when does it make sense to shift? Only if the rate differential is higher than 50 basis points can a borrower consider it. For instance, a few home loan borrowers with SBI will benefit very little from shifting to a new loan product carrying a lower rate.
This is because, to shift to new product whose rate is lower by 25 basis points (as compared to a loan taken in early 2012), SBI charges a one per cent conversion fee. The savings made from the lowered interest will not cover this conversion fee payout if the remaining tenure of the loan is very low. For instance, for a 10-year loan from SBI, it takes almost eight years to recover the conversion fee charged (here, we haven’t considered the time value of money).
Hence a borrower with a lower differential is better off staying put with his existing loan.
In such a case, borrowers can negotiate with their current lenders to reduce the rates on existing loans or give a better rate on new loans at low conversion fee.
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