What to Do If Interest Rates Continue to Rise?

SBI has increased its MCLR (Marginal Cost of Funds based lending rate) multiple times (1, 2, 3) in the recent months. MCLR is the benchmark for floating rate loans. Therefore, if you have borrowed from SBI, your loan interest rate would have already gone up in the recent months. Never a happy situation for the borrowers. As a borrower, what are your options in such a scenario? Please understand I do not want to comment upon whether the interest rates will continue to rise from here. Too many variables are involved. I do not want to get into a game of forecast. I want to discuss your options if the interest rates continue their upward move (or when you expect interest rates to go up).

On the assets side, it may make sense to reduce duration of your bond portfolio (debt mutual fund portfolio). Additionally, you can expect your bank fixed deposits to yield more. On the liabilities front (i.e. loans), you may have a problem. If you are on a floating rate loan, your EMI or the loan tenure will go up depending on your loan contract. Let’s first see how a rate hike will affect your loan EMI.

How Your Loan EMI or Loan Tenure Will Be Affected?

When the interest rate for your loan is hiked, either your loan EMI is increased (and the loan tenure remains same) or the loan tenure is increased (and loan EMI remains constant). The action depends on your loan contract and your choice. Change in loan tenure (and EMI kept constant) is typically the default option. The impact of rate hike may depend on multiple factors such as your outstanding loan, interest rate, remaining tenure and of course the quantum of rate hike/cut.

Let’s consider an example. Let’s assume you have an outstanding loan of Rs 20 lacs and the remaining loan tenure of 15 years. I show the impact of loan EMI (or loan tenure) for different levels of rate hikes.

O/S loan amount	₹ 20,00,000
Remaining loan tenure (months)	180
Interest Rate	9%
Current EMI	₹ 20,285
Rate Hike	0.25%	0.50%	0.75%	1%	1.25%	1.50%
Option 1
New EMI (Loan Tenure constant)	20,584	20,884	21,187	21,492	21,799	22,108
Increase in EMI	299	599	902	1,207	1,514	1,823
Option 2
New Loan Tenure (EMI constant)	185.8	192.3	199.6	207.7	217.1	227.9
Increase in Loan Tenure (months)	5.8	12.3	19.6	27.7	37.1	47.9

 

A higher EMI is a direct hit to your monthly budget. Keeping the EMI constant and increasing the loan tenure may seem like an easier option. However, any additional EMIs that you pay is the additional interest that you choose to pay during the loan tenure. Well, if the higher EMI does not pinch your budget, a higher EMI is a better choice. By increasing the EMI and keeping loan tenure, you will save a lot on interest cost. Please understand that the interest rate of loan stays the same in both cases. The difference will only be in absolute interest cost.

For instance, in case of rate hike by 1%, if you choose to increase EMI, the total interest cost over the remaining tenor will be Rs 18.68 lacs. On the other hand, if you keep the EMI constant and increase the tenure, the total interest cost during the remaining tenure will be Rs 22.13 lacs.

What Can You Do?

Frankly, there is not much that you can do. Floating rate loans have their pros and cons. Perhaps, you benefited when the interest rates went down during the last few years. I say “Perhaps” because the banks are never very keen to pass on the rate cuts. No such lethargy when it comes to rate hikes. Now if the interest rates continue going up, you will have to take the hit. Here are still a few points that you must keep in mind.

#1 The Impact May Not Be Immediate

Floating rate loans are given at a spread over the MCLR.

Interest rate you pay = MCLR + Spread

Spread for your loan remains constant during the loan tenure. On the other hand, the bank can change MCLR every month (depending on its cost of funds). However, MCLR linked loans have a reset date. Therefore, if your interest rate reset date is say after 8 months, increase (or decrease) in MCLR will not affect your loan interest rate for the next 8 months. Therefore, even if the bank hikes MCLR for your loan, you may not get affected for a few months.

#2 You Can Prepay a Portion of the Loan

If you have some cash surplus with you, you can always prepay a portion of your loan. This may help keep your EMI constant. For instance, in the example shown, if the interest rate is increased by 0.5%, the EMI goes up from Rs 20,285 to Rs 20,884, an increase of Rs 600 per month. However, if you prepay a portion of your loan, you can keep both EMI and the loan tenure constant.  Let’s continue with the example discussed above.

O/S loan amount	₹ 20,00,000
Remaining loan tenure (months)	180
Interest Rate	9%
Current EMI	₹ 20,285
Rate Hike	0.25%	0.50%	0.75%	1%	1.25%	1.50%
Loan prepayment needed to keep EMI and loan tenure constant
Prepayment needed	₹ 29,005	₹ 57,379	₹ 85,138	₹ 1,12,299	₹ 1,38,877	₹ 1,64,886

Of course, I assume you have a small cash pool that you can access during such times. Note that any pre-payment is also eligible for tax benefit under Section 80C of the Income Tax Act.

#3 Balance Transfer May Be an Option

Balance transfer is also an option that you can explore. However, in this case, this approach may not be as effective. Balance transfer can be a more useful approach when you are stuck in a high cost loan (you took a loan from the bank/NBFC where the interest rates in general are on the higher side). In this case, when the rates are rising, the hikes typically come across the board. There may be delays of a few months from one bank to another. However, no financial institution can remain unaffected when the rates in the economy are rising. Moreover, a balance transfer will have its own set of operational hassles and costs. You can’t simply look at the current interest rates to decide whether you should transfer your loan to another bank. Don’t fall for the teaser rates.