Managing your EMIs

In addition to companies, there is another set of borrowers who may have to closely watch Reserve Bank of India's actions; those of us who have taken loans.

As RBI continues to raise its policy rates, banks are passing on their rising costs to customers in order to protect their own margins. Most banks excluding SBI actually raised their base rate (their benchmark rates for lending), by as much as 1.5 percentage points after the recent RBI action.

If you have a home loan or a car loan outstanding, how do the rising base rates of banks affect you? We take a look at the impact of these rate hikes on the monthly outgo for borrowers.

We also try addressing the dilemma investors face while choosing between fixed rate loans and floating rate ones.

Floating rate borrowers

On every one lakh rupees borrowed for a term of 15 years, a 0.5 percentage point rise in interest rates would increase the monthly outgo (equated monthly instalment ) by Rs 29. This may seem small but depending on the size of the loan and quantum of the hike, the amount may add up to a lot.

For instance, for a 20-year, Rs 20 lakh loan with a floating rate of 8 percent the outgo would rise by Rs 1,920 per month just by virtue of base rate going up by 1.5 percentage points. This means the EMI may go up from Rs 16,720 to Rs 18,640. In case of auto loans and other personal loans, the rise in EMI is lower given the shorter tenor of these products and the principal is repaid at a faster rate than in case of longer-maturity instruments.

As a borrower, you also need to reckon with the dent that the higher outgo may make on your disposable income. If your EMI was just 40 per cent of your income earned before this rate hike, it would now be 45 per cent.

However, borrowers need not get discouraged by the rising interest rates bloating their EMIs. They have other choices too. Once rates are hiked, banks usually intimate all their borrowers about it .

If the borrower is not in a position to shell out a higher EMI, the bank simply increases the term for which you pay the loan, instead of stepping up the EMI. However, there are cases where the borrower is ready to prepay the loan, close it ahead of its time, to reduce the impact of EMIs. This would also be welcomed by the banks.

In cases where the loan's term has already been stretched to the maximum, the EMI may be hiked even though the borrower may not be well positioned to service it.

Fixed versus floating

Given this scenario of rising interest rates affecting the borrowers, should investors have locked into the fixed rate loans or loans for which interest rates are fixed at a flat percentage over the entire tenure?

Fixed rate loans in India today, are not per se fixed for a very long term. Such loans are usually “reset” after 2, 3 or 5 years. Even if you manage to go in for fixed rate loans with such a reset clause, the product in the current form is unattractive.

For one, the rates are fixed in such a way that they are much costlier than floating rate ones. Then, by opting for a fixed rate loans, you may be narrowing your choice of banks. Some banks have even discontinued fixed-home products so that they can pass on the interest rate hikes to borrowers.

Secondly, one need to remember that interest rates may move both ways. If you lock into fixed rates just as interest rates are peaking you may lock-in at expensive rates. For instance, the fixed interest rate on an Indian Bank housing loan was at 11 per cent during the period January 2009 with a two-year resets. If you took that loan in January 2011 it would have been reset a higher or similar rates not giving any respite for the fixed rate borrower.

Additionally, the floating rate/teaser rate borrowers enjoyed low rates during this time, which the fixed rate borrowers didn't.

Five years ago, if someone had to opt for a loan he would have had ample choice to take a call between fixed and the floating rate loans. However, in the current scenario, there's not much choice beyond floating rates.

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