Loan Interest Rates Are Going Down. Should You Refinance Now?

The Reserve Bank of India has been cutting repo rates for over a year now. We might argue whether the loan interest rate for the existing borrowers are falling enough or not. However, the new borrowers are clearly getting attractive deals.

In a previous post, I wrote about Covid-19 personal loans from public sector banks, where the rates were very attractive. One of the banks was offerings a personal loan at 8% p.a. Recently, I read about State Bank of India offering gold loans at 7.5% p.a., which is quite low for a gold loan.

Why Are Loan Rates Going Down?

There are not many happy reasons behind such low interest rates. Growth is struggling. As I see, credit growth is faltering too. Fortunately, inflation is benign and that gives scope to the Reserve Bank to cut repo rates. On May 22nd, the RBI cut Repo rate to 4% p.a. The Reserve Repo (the rate at which the banks deposit money with RBI) was cut to 3.35% p.a. The rate is even lower than the Savings bank account rate (usually 4%). Hence, the banks need to figure out ways to lend the depositors money productively. Credit demand is subdued. The lending competition is intense, which is also translating to lower rates for new loans.

I understand “Low” is a subjective word. In the near future, we might see even lower rates. However, if my memory serves me right, we have not seen such low rates in the recent past. Can we use these developments to our advantage?

How Do We Use This Information?

Should you start looking for a loan? I don’t think so. This is clearly NOT a suggestion that you should start looking out for a loan, secured or unsecured. Your desire for a loan shall depend on your requirements, cashflows and the confidence in your ability to repay. Moreover, these loans are floating rate loans. As and when, the interest rates start rising (though it seems some time away), your new loan interest rate will start rising too.

If you own a high cost debt, this might a good time to revisit your options to refinance or foreclose the expensive debt.

For instance, if you are making minimum payments on your credit card and consequently paying 36-42% p.a. on the outstanding, it is a good idea to explore cheap loan options and close the more expensive loan. You can look at a cheap personal loan. You can explore a gold loan product, as mentioned above. There is a good amount of money to be saved.

If your home loan interest rate is high (you are stuck with MCLR or base rate loan), you can consider refinancing at a lower rate. With home loans, shifting to different benchmark with the existing lender is operationally convenient. If your loan is with a housing finance company (HFC) and it is NOT offering you a good rate (the external benchmark rule does not apply to HFCs), you can consider refinancing your loan with a bank.

What Aspects Should You Consider When Refinancing an Existing Higher Rate Loan?

Don’t just look at the interest rates for comparison. Consider the all-in cost and benefit. Consider processing fees and ancillary charges for the new loan and the foreclosure charges for the existing loan. Since these are upfront costs, these can nullify the entire benefit from shifting.

For instance, let’s say you plan to take a new loan at 8% and foreclose an existing loan at 15%. Both loans are for 1-year tenure. The existing loan has a foreclosure penalty of 4%. The new loan has a processing fee of 1%. You add 18% GST to this. The switch transaction has a non-interest cost of ~6% of the loan amount, nullifying almost the entire cost advantage. Not worth your time.

Of course, if the loan tenure were longer, you could have considered these costs spread over the longer tenure. In that case, you could have seen the benefit of a lower interest rate. As we have discussed, high interest rate is lesser problem for short term loans. The non-interest charges in the existing and the new loan are important and must be considered in your analysis.

Consider the tenures of new and existing loans. Let’s say, your existing personal loan has a pending repayment tenure of 4 years. The interest rate is 13% p.a. The outstanding amount is Rs 5 lacs. You want to take a gold loan at 7.5% and close the personal loan. Fine. What about the tenures? You have 4 years to repay your personal loan.  You must repay the gold loan after 1 year (assuming you wouldn’t have an option to refinance).

For instance, in the personal loan mentioned above, you will have to pay an EMI of Rs. 13,413 over the next 4 years. That makes it Rs 1.61 lacs over the next 12 months. In case of the gold loan, even though the rate is much lower, you will have to pay Rs 5.37 lacs (bullet repayment) to close the loan. Your cash flows may not permit that. No matter how we spin it, all the loans, whether high cost or low cost, must be repaid. Hence, be cognizant of your cash flows and your repayment ability.