You take a Rs 50 lacs home loan for 15 years at 8% p.a. The EMI for the loan shall be Rs 47,782. Interest rates keep changing. When the interest rate rises, the default bank action is to keep the EMI constant and increase the loan tenure.
Let’s say the interest rate for your loan rose to 10% p.a. after 2 years. Further rose to 12% p.a. after 4 years. You never bothered to check the loan statements. You just kept paying the EMIs diligently. After 15 years, you are under the impression that the entire loan would have been paid off. Or at least the bulk of it. You reach out to the bank to enquire about the loan closure process. The bank says, “Not so soon.” You must pay the EMI for 10 more years. 118 months to be precise.
You are shocked. Haven’t you been paying the EMI for the last 15 years? Why do you have to pay for ~10 more years?
Has Your Bank Tricked You?
The bank is not tricking you. That’s how loan mathematics works. In a rising interest rate scenario, keeping the EMI constant results in the increase of loan tenure.
The example considered above is hypothetical and may even seem a bit extreme. However, it still shows the impact of rising interest rates on loan tenures.
After 2 years (when the interest rate increased from 8% to 10%, the remaining loan tenure jumped from 156 months (13 years) to 197 months (16 years and 3 months). The original loan tenure was 15 years.
After 4 years (when the interest rate increased from 10% to 12%), the remaining loan tenure shot up from 174 months to 248 months. Hence, after paying EMIs for 4 years in a 15-year loan, you still have to pay for a further 20 years and 8 months.
Surprising, no? But that’s what keeping EMI constant in a rising interest rate scenario can do to your home loan tenure. Tough luck for the borrower but if all this is fair, where is the problem? Well, there is one, that of an informed decision.
Would you have approached the situation differently (rising interest rates) if you had known the effect of keeping the EMI constant? What if you retire in 10 years and the bank is extending the tenure to 20 years?
Why Is RBI Concerned?
Most borrowers don’t really understand how reducing balance home loan calculations work. Even if you did, it is difficult to appreciate how small changes in interest rates can increase the loan tenure sharply. You need to open a spreadsheet software or an online loan calculator to figure this out. You can’t do these calculations mentally.
If the bank had communicated to the borrower that keeping the EMI constant would increase the loan tenure to such an extent and sought an explicit consent, the borrower may have acted differently. He/she may have opted to partly (or fully) prepay the loan. Or even opted to increase the EMI and kept the loan tenure constant.
There is no right or wrong decision here. RBI just wants you to make an informed decision. The Central Bank does not want the banks to decide on behalf of the borrower.
In the Statement of Development and Regulation dated August 10, 2023 (after the Monetary policy announcement), the RBI stated the following:
As you can see, the Reserve Bank proposes to put in place a framework for clear communication with the borrowers at the time of resetting EMIs or loan tenure. The RBI does not specify explicit consent here. We will get to know more when the central bank comes out with the detailed guidelines.
RBI statement also talks about an option to switch to fixed rate loan or foreclose the loan, and about the transparent disclosure of charges.
The RBI is trying to provide any possible relief to the borrowers. Just trying to ensure proper communication and transparency so that the borrowers can make an informed choice.
While I have no data to support my claims, I am inclined to believe that banks have not done themselves proud in terms of communicating such changes to the borrowers. The RBI statement seems to suggest the same.
You Still Have to Act Responsibly
That banks don’t communicate properly is no excuse to you being completely unaware.
Be responsible. And your responsibility does not end with paying the EMI.
Be aware. Read those loan statements that the banks send over emails or through post. Log into the loan portal regularly and get a sense of your home loan interest and tenure. If something seems out of place, dig deeper.
For the interest rates, get an idea about what others are paying in your circle. If you are paying a much higher rate, it is a red flag. You need to check the reason with your bank.
There have been instances where borrowers are paying a higher rate of interest simply because their loan is linked to an old benchmark. Such borrowers just had to ask the bank to reduce the interest rate and the bank obliged.
If you are expecting your bank to reach out to you for a favorable change, you still don’t know your bank.