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Money Jan 31, 2013

Banks cut base rate: Should you lower your home loan EMIs?

By Bindisha Sarang

At least three banks announced a reduction in their base rates since January 29, after the Reserve Bank of India cut its key policy rate and Cash Reserve Ratio (CRR) for banks by 25 basis points. The three banks are State Bank of India, IDBI Bank , and Royal Bank of Scotland .

SBI cut it's base rate by 5 basis points from 9.75 percent to 9.70 percent, effective February 4. While HDFC Bank Ltd was selective in reducing rates on auto loan, though the bank has not reduced base rate, yet. Federal Bank also reduced rates on auto loan for three years. While RBS reduced its base rate by 0.75 percent to 9 percent, IDBI bank reduced the base rate by 25 basis points, or 0.25 percentage point. Base rate is a rate below which a bank cannot lend. In fact, IDBI also reduced its benchmark prime lending rate (BPLR) by 25 basis points, making home loan cheaper for those who are still stuck on the BPLR system for their loan. More banks are expected to reduce their base rate in the near future. Let's see what it really means for you.

Reuters

If you are about to take a loan, let's say to buy a home, you will get it cheaper than what the bank was offering prior to 1 February, when the new rate becomes effective.Reuters

New borrowers: If you are about to take a loan, let's say to buy a home, you will get it cheaper than what the bank was offering prior to 1 February, when the new rate becomes effective.

Existing borrowers: If you already have a loan, this means that your home loan interest rate just got cheaper by 25 basis points. Keep in mind that the interest rate on home loan is made of two parts -the base rate, which is the variable component, and the load, aka mark-up, which is the fixed component that changes on a case-to-case basis.

So, if your home loan was 11.50 percent, the base rate was 10.50 percent and the load was 1 percent. Now, when IDBI decreases their base rate by 25 basis points and the new base rate stands at 10.25, your new home loan interest will also reduce to 11.25 percent, where the base rate will be 10.25 percent and the load or mark-up will remain 1 percent.

What happens: Most newspapers have said that your home loan EMI's will decrease. But it's hardly true. "Decrease in EMI is more in theory, but it does not happen in practice. In practice, banks do not reduce your EMIs. Instead, they simply reduce the loan tenor," said Vipul Patel, CEO, Home Loan Advisors. Why so? For a 20-year home loan tenor, if your interest rate swings either way up or down say 5-6 times, it's a headache for you as well as your bank to cancel the old ECS (for old EMI amounts) and set new ECS (new EMI amounts). So, for operational purposes, banks will reduce the tenor of the loan, while keeping the EMI same, in case of a cut in their base rate. Likewise, if the base rate increases, your home loan tenor increases while EMI remains the same.

Is it a bad thing? Not at all. On the contrary, it is always better to keep paying the same EMI amount, even when there is a reduction in the interest rate you pay. After all, the sooner you pay off the loan, the better for you. You will be able to own the house sooner. Also, the total cost of the loan decreases.

For example, if you've taken a Rs 50 lakh loan, at an interest rate of 11.50 percent (base 10.50 percent + load 1 percent), your home loan EMI stands at Rs 53,322. Assuming after a year, the new loan outstanding amount stands at Rs 49,31,612. Now assuming that your bank cuts base rate by 25 basis points, the new interest rate on your loan is 11.25%.

Case 1: You continue to pay the same EMI of Rs 53,322, you loan tenor will decrease to around 18.08 years. And the total interest out go for this period will be 65,99,472

Case 2: You continue to pay a new (lower) EMI of Rs 52,487, you would take 19 year to pay off the loan, and the total interest out go for this period would be Rs 70,35,424

So, if you go for case 1, i.e. when you hold your EMI amount, you will not only take around one year lesser to get rid off the loan, but also it becomes cheaper by around 4.35 lakh.

"Even after a reduction in the base rate, if you can afford to pay the higher EMI amount-if you don't have cash flow constraints-you should continue to pay the old EMI amount. But, if you want to lower the EMI amount, you will have to approach the bank with a request," said Patel. Banks will not take an initiative to lower your EMI amount, by setting new ECS, they will simply reduce the tenor.

Now that you know what base rate cut by banks means for you, make the most of this information. More banks are expected to follow suit, and this time let's hope your bank announces a cut in their base rate too.

by Bindisha Sarang

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