How does the Rate Hike Impact my Financial Plan?

RBI has increased the reverse repo and repo rates by another 50 basis points this week. The increase was certainly expected but the quantum of increase came as a surprise to the entire industry. The market was expecting an increase of 25 basis points but the rate hike was of 50 basis points.

Increases in these rates have both negative and positive impact. The negative impact is on the liabilities which will become costly than what they are currently. The positive impact of this increase is that now people will be able to earn higher returns on fixed deposits.

Looking at the past few months, where the credit growth has declined, it may happen that the banks may not pass on the entire burden of this increase in interest rate to the new customers. But some of the increase will definitely be passed on to the customers. The existing customers are always the one who are affected more than the new customers in case of such rate hikes.

In the event of increase in loan rates, the banks may either choose to increase your EMI which you pay every month or they may increase the tenure of the loan. Generally, the banks choose to increase the tenure of the loan and keep the EMI unchanged broadly for two main reasons.

Firstly, the banks already have post dated cheque or ECS instructions for the EMI amount and any change in the EMI will mean changing all the previous instructions. Thus administratively, it suits the banks better to keep the EMI same and increase the tenure. Secondly, any increase in tenure does not impact the monthly household budget, hence the chances of default do not increase.

However there is a limit upto which the banks can keep increasing the tenure. Obviously the increase in tenure can not be such that the loan repayments exceed even your retirement age. Thus beyond a point the bank is forced to increase the EMI rather than tenure.

Existing loan customers are the ones who suffer the most due to these interest rate hikes. The floating interest rates are generally linked to base rate or the prime lending rate. After the increase in interest rates, the banks generally increase their base rates and prime-lending rate.

This directly impacts the existing customers as their loans become costly. But for new customers the banks may reduce the spread over the base rate and thus charge them less. An example will illustrate this point : Suppose the bank’s current base rate is 9.50% and you have got an interest rate of Base rate plus 1 %. Your effective interest rate is thus 10.50% (9.50% + 1%). Now if the banks increase the base rate by 0.50% to 10% your effective rate becomes 11% (10% + 1%).

The bank may start charging new consumers at base rate plus 0.75% thus charging them only 10.75% (10% plus 0.75%). This kind of discriminatory changes have already happened in the last round of increases and will definitely happen this time around also as the increases are announced.

People who took loan around 2-3 years back have been the worse victims of these discriminatory interest rate hikes. The home loan rates were then in a range of 8 to 9% per annum taken on the prime lending rates. These rates have gone up to 12 to 14% per annum for the customers.

These customers should immediately shift to the new base rate regime, which is relatively more transparent.  The first step should be to find out the existing home loan rates. These rates are publicly available on various websites like www.apnapaisa.com and also many newspapers carry them on a regular basis. If you are paying more interest rate than what other lenders are offering, you should talk to your lender first and see if he is ready to shift you to a lower interest rate on the base rate system on payment of some fees. If the lender doesn’t give you that option or does not give you the same rate that he is charging to new consumers, then you should shift your loan to another lender who is offering you a better interest rate.

Don’t worry about the prepayment charges. There are plenty of banks who will takeover the loan as well as give you a loan for the prepayment charge and have nil processing charges. You do not need to do complicated calculations to find out if the shift makes sense. If the tenure of the new loan is lower than the old one (with EMI remaining the same) and  there is no cash outflow from your pocket (remember you are getting an enhanced loan amount that also covers the prepayment charge) you are getting a better deal.

Remember it is sheer inertia that is probably keeping you from saving thousands of rupees every month.

With the interest rates nearing its peak (let’s hope that it is indeed so) it is a good time to lock in your fixed income investments at the higher rates.

Currently fixed deposits are offering return in a range of 8 to 10% per annum for a period in excess of 1 year. AAA rated company deposits will also become attractive options. In fact Fixed Maturity Plans will really offer the best post tax returns because of their structuring.

So all in all , we live in “interest”ing times but need to act to protect our own interests (pun intended).

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