Factors to Consider When Refinancing Home Loan

I have been getting many queries from home loan borrowers pertaining to shift from base rate to MCLR? I have discussed this aspect in an earlier post. Even though the option of switching from base rate to MCLR is worth exploring, there is another option that many borrowers can exercise when it comes to Home loans: Home Loan Refinancing or Home Loan Balance Transfer.

What Is the Difference?

When you consider switching from base rate to MCLR, you are merely considering changing interest rate calculation methodology with the same lender.  However, in case of home loan balance transfer (or refinancing), you shift to another lender. In case of home loan refinancing, loan from the new lender is used to settle any outstanding amount from the existing lender. Your loan engagement with the old lender ends. In the future, you make payments to the new lender.

Why Would You Opt for Home Loan Refinancing?

There could be many reasons to look for home loan refinancing. Common reasons are:

• In search of lower interest rates
• Shift from fixed rate loan to floating rate loan
• Dissatisfaction with service offered by the banks
• Shifting loan from NBFC to bank after credit profile improvement

Banks are not always keen to pass rate cuts to existing borrowers while they leave no stone unturned in attracting new customers. This is bound to disappoint many borrowers and they may be keen to move to another lender. By shifting to a lower interest rate, you can save a lot of money over the loan term.

For instance, if you have an outstanding loan of Rs 50 lacs. Remaining tenor is 15 years and interest rate is 9.5% p.a. EMI is Rs 52,211. If you can manage to reduce the loan interest to 8.75% per annum:

1. EMI will be only Rs 49,972 and you get to save Rs 4.02 lacs over 15 years
2. If you keep the EMI constant and change the tenor instead, the loan will be repaid in ~165 EMIs. Hence, you save about 15 EMIs. i.e., a saving of Rs 7.85 lacs

Do note, under the first method, the interest saving is spread across 15 years (loan tenor). Under the second method, the saving is concentrated in the final year (you save last 11 EMIs). You can see there is benefit if you find a good deal for home loan refinancing.

What Are the Aspects You Must Consider?

• Pre-payment penalty: Though banks cannot charge any pre-payment penalty for floating rate loans, they can still charge penalty for fixed rate loans. Hence, if you have a fixed rate loan, do consider the impact of pre-payment penalty.
• Consider ancillary charges: Banks (both existing and new) may impose one or the other kind of charges for effecting the home loan transfer. Processing fee is quite common. Consider the impact of all the charges. Do not get fixated with the only the difference in interest rates.
• Avoid teaser loans: As mentioned before, banks may go to any length to source new loans. It is quite possible that the new lender is offering lower interest rate (as compared to existing lender) only for a limited duration. After the period is over, the interest rate may inch back higher. You need to be aware of such offers. If you are still keen on such offers, get better understanding of how interest rate will change once the promotion period expires.
• Loan amount, tenor, difference in interest rates and fees: Apart from aspects mentioned above, as in the case of decision to switch from base rate to MCRL, the impact of home loan refinance (at a lower rate) also depends on loan outstanding, outstanding tenor, rate differential and any fee/costs involved.
  • Higher the outstanding loan amount, the more you will benefit by shifting to a lower rate.
  • Higher the outstanding loan tenor, the more you will benefit by shifting to a lower rate.
  • Higher the interest rate differential, greater the benefit.
  • On the flip side, higher cost/fees involved in loan refinancing will bring down the benefit.

Points to Note

1. If you opt for home loan refinancing, you will have to switch to MCLR regime with the new lender. This is because, with effect from April 1, 2016, all new floating rate loans have to be offered under MCLR.
2. For the new lender, it is a fresh loan and hence it has to be on MCLR. There is no going back to base rate. Hence, be prepared to adjust with MCLR regime.
3. It is quite possible that the existing lender may make a counter offer (at a rate lower than existing rate) once it gets to know about the offer from new lender.  Consider such offer too.
4. Do note any fee has to be paid upfront while the benefit of a lower interest rate will be spread over the loan term (if you keep tenor constant and change EMI) or towards the end of the loan tenor (if you keep EMI constant and change loan tenor).
5. Hence, focus on absolute cost and benefit may misguide you. Discounting savings in the future at an appropriate rate will give you a more accurate answer.

I have discussed such calculations in detail in the post on switching from base rate to MCLR. Do a proper cost-benefit analysis before you make the decision. The benefit must be worth your time, money and effort.