I got this query from one of the readers. He had taken a home loan from a leading housing finance company.
| Original Loan Amount | Rs 39,12,633 |
| Loan Outstanding | Rs 37,94,900 |
| Original Loan Tenure | 240 months |
| Remaining Loan Tenure | 221 months |
| Current Rate of Interest | 9.1% |
| EMI | Rs 35,455 |
The loan interest rates have fallen sharply over the last 18-24 months.
The Switching Offer
When the borrower approached the lender for a lower rate, the lender offered to reduce the loan interest rate to 8% p.a. for a switch fee of Rs 1.23 lacs. As a borrower, how should you evaluate this offer? Should you accept this offer or continue at a higher rate of interest? You can evaluate the offer in many ways.
Approach 1 — Determine Time Taken to Recover Switch Fee (Revised Loan Tenure)
You pay the switching fee of Rs 1.23 lacs and reduce the loan tenure to 188 months. On a loan of Rs 37.94 lacs, by paying 1.1% p.a. less, you save ~Rs 41,000 in interest in the first year. So, it will take about 3 years to recover the switch fee (i.e., Rs 1.23 lacs / 41,000). This is a very crude calculation. (For exact interest savings under reducing rate, see below table). And then you pay the lower interest rate for the entire tenure (and not just 3 years). We have seen much easier switching terms in banks where you recover the switch fee within a few months. Here, you recover the fee in 3 years. Does not look nice in comparison. However, in absence of other options, this looks a fine choice.
| Switch Fee | Rs 1,23,000 |
| Loan Outstanding | Rs 37,94,900 |
| Keeping EMI Constant | Rs 35,455 |
| Original Loan Tenure | 221 months |
| Original Interest Rate | 9.1% |
| Interest Paid (1st Year) | Rs 3,41,908 |
| Interest Paid (2nd Year) | Rs 3,33,980 |
| Interest Paid (3rd Year) | Rs 3,25,299 |
| Interest Paid in 3 Years (@ 9.1% interest rate) (A) | Rs 10,01,187 |
| Revised Loan Tenure | 188 months |
| Revised Interest Rate | 8% |
| Interest Paid (1st Year) | Rs 2,99,023 |
| Interest Paid (2nd Year) | Rs 2,88,528 |
| Interest Paid (3rd Year) | Rs 2,77,163 |
| Interest Paid in 3 Years (@ 8% interest rate) (B) | Rs 8,64,714 |
| Difference in Interest Paid in 3 Years (i.e., time taken to recover Switch Fee) (A-B) | Rs 1,36,473 |
Here’s another alternative to consider — You could have used Rs 1.23 lacs to part prepay the loan. In that case, your loan outstanding goes down from Rs 37.94 lacs to Rs 36.71 lacs. If the EMI (and interest rate) remains the same, the loan will get repaid in 203 months (compared to 188 months after the switch). Clearly, switching to a lower rate by paying the fee is a better option compared to prepaying with the loan using the fee amount.
Approach 2 — Determine Time Taken to Recover Switch Fee (Revised EMI)
You pay the switching fee of Rs 1.23 lacs and adjust the EMI. With a lower interest rate, the EMI will go down to Rs 32,868. Compared to the existing scenario, this will lead to a monthly saving of Rs 2,587. You take about 48 months to recover the switching fee. Not bad. Your loan tenure is 221 months. Looks fine again.
| Switch Fee (A) | Rs 1,23,000 |
| Loan Tenure (B) | 221 months |
| Original EMI (C) | Rs 35,455 |
| Revised EMI (D) | Rs 32,868.38 |
| Monthly Savings (E= C – D) | Rs 2,586.62 |
| Total Savings (F= B x E) | Rs 5,71,643 |
| Time to Recover Switch Fee (A ÷ E) | ~48 months |
Approach 3 — Switching Fee as an Investment
By paying Rs 1.23 lacs upfront (and keeping the EMI constant), your home loan will get repaid in 188 months. So, you save a cool 33 EMIs by paying the switch fee of Rs 1.23 lacs. You save 33 X 35,455 = Rs 11.70 lacs by paying Rs 1.23 lacs upfront.
| Switch Fee (A) | Rs 1,23,000 |
| Keeping EMI Constant (B) | Rs 35,455 |
| Original Tenure (C) | 221 months |
| Revised Tenure (D) | 188 months |
| Months Reduced (E= C – D) | 33 |
| Total Savings (F= B x E) | Rs 11,70,015 |
Remember, your switching fee expense is upfront. The savings come in the form of EMIs saved beyond the 188th month. Is that good or bad?
Let us assume you made an investment of Rs 1.23 lacs. You got Rs 35,455 for 33 months starting 189th month. The APR is 13.28% p.a., much higher than your loan interest rate. So, switching to a lower interest rate by paying this fee looks like a fine choice.
Approach 4 — What if You Prepay the Loan after the Switch?
The above calculations are fine. However, such calculations are likely to overstate the benefits of switching to a lower rate of interest. Why? This is because the assumption in all the scenarios discussed above is that you will let your home loan run its full course. Usually, we tend to prepay the home loans much sooner. Usually in about 7 to 9 years. If the home loan is prepaid, the benefit of a lower rate of interest goes down automatically. The benefit can be much lesser than calculated in the above examples.
Let us consider an extreme scenario. The borrower prepays the entire home loan after 1 year. So, the borrower reduces the interest rate by 1.1% from 9.1% to 8% per annum. Over the next 1 year, he would have saved about Rs 41,000 in interest cost. However, for this, he paid Rs 1.23 lacs. Does not make sense, does it? Before shelling out big amounts in switching fees, you must consider this possibility of your plans for loan prepayment.
Let us consider a more plausible scenario. The borrower prepays Rs 3 lacs every year. At the end of the 7th year, he prepays whatever is left and closes the loan.
- Case 1: You keep the 1.23 lacs in your pocket and stick to the existing rate of 9.1% p.a. EMI remains same. You prepay Rs 3 lacs at the end of each year (12th, 24th, 36th month and so on). At the end of the 7th year, you must pay Rs 5.12 lacs to close the loan.
- Case 2: You pay the switching fee of Rs 1.23 lacs. Interest rate goes down to 8% p.a. EMI remains constant. You prepay Rs 3 lacs at the end of each year. At the end of the 7th year, you must pay Rs 2.54 lacs to close the loan.
| Loan Outstanding | Rs 37,94,900 | ||
| Original Interest rate | 9.10% | ||
| Original Tenure | 240 | ||
| Remaining Months | 221 | ||
| EMI | Rs 35,455 | ||
| Case 1 (A) | Case 2 (B) | Difference (A-B) | |
| Switch Fee | – | Rs 1,23,000 | |
| Revised Interest Rate | 9.1% | 8% | |
| Yearly Prepayment Amount (Paid on 12th, 24th, 36th month etc.) | Rs 3,00,000 | Rs 3,00,000 | |
| Outstanding Loan at the end of 5th Year | Rs 17,76,969 | Rs 15,78,156 | Rs 1,98,813 |
| Outstanding Loan at the end of 7th Year | Rs 5,12,686 | Rs 2,54,773 | Rs 2,57,913 |
Case 2 costs Rs 2.58 lacs less (i.e., 5.12 lacs – 2.54 lacs) compared to Case 1. However, you paid Rs 1.23 lacs upfront in switching fees. Rs 1.23 lacs will become Rs 2.58 lacs in 7 years for a 11.15% p.a. return. While this is not bad, you must appreciate that you are losing a lot of flexibility. Rs 1.23 lacs is gone, irrespective of whether you finish the loan in 5 years, 7 years, or 10 years.
If you were to close the loan at the end of 5th year, the difference in foreclosure amount will only be Rs 1.99 lacs between Case 1 and Case 2. For this, you pay Rs 1.23 lacs upfront. Not worth it.
In Summary — What Should You Do?
In my opinion, Rs 1.23 lacs is too high a switching fee. In fact, from the borrower’s perspective, these terms are atrocious. I have seen lenders (based on readers’ feedback) offering much generous terms to borrowers where the switching fee is recovered in just a few months. Here, it takes a few years.
We have NOT considered the possibility of refinancing the loan with another lender in this post. For loan refinancing, you will incur processing fee and a few other documentation related costs. It requires more work too. However, you are likely to get a better deal while switching to another lender. At the same time, I do not have much idea about the borrower’s credit profile, and I work with an assumption that the new lender will sanction the loan. Trust your judgement on this. When your existing lender offers you such a raw deal, loan refinancing is an option worth exploring.