Rising Loan Interest Rates – What Should One Do

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The last year saw constant hikes in the Cash Reserve Ratio and the Repo rates by the Reserve Bank of India resulting in an upward movement of loan interest rates. For the common man, such rise in rates is definitely a setback. Borrowers face tight financial constraints and coupled with a rise in inflation, it sure are tough times. Here are some practical options available to help you ease the loan burden at such times of high interest rates.

The most common option when the interest rate goes up is to either increase the EMI or increase the tenure of the loan. So which one of these is actually better?

  • Increasing the loan tenure and keeping the EMI constant

When interest rates rise, a sudden rise in EMI could be quite a pinch especially for individuals in tight financial conditions, those with more than one debt and those nearing retirement. At such times, keeping the EMI constant and increasing the loan tenure works out as an ideal option. Lenders accommodate the interest rate increase in the increased loan tenure and retain the monthly outflow at the same level. However keep in mind that by doing so in the long run, you end up paying more interest for your loan. Also, some lenders may not permit an increase in loan tenure beyond a specific term, especially for those nearing retirement. So check with your lender on the possible way out.

  • Increasing the EMI, with the same loan tenure

For those who can afford it, many financial experts, often recommend going in for a higher EMI and maintaining the same loan tenure. This is because, by increasing the EMI and retaining the same loan tenure, though the monthly outflow is higher, the total cost of the loan works out to be much lesser. The increase in EMI must be within your financial capacity to make payments every month.

 Other Options Available

  • Loan Prepayment

For many borrowers, loan prepayment could be the last option in times of high interest rates, as it primarily depends upon the liquidity position. When going in for a prepayment, remember to check on the prepayment charges the lender would quote. Banks generally levy 1.5% to 2% for prepaying the whole loan amount. So consider prepayment, only if the cost of prepaying the loan works out to be much lesser than the rise in interest rate.

Loans could also be part prepaid. By doing so, the loan principal value comes down, thus reducing the total interest amount you’ll pay. The EMI would reduce, or at least, the same EMI would remain even after an interest rate increase. Some banks may not even charge a penalty for up to a certain percentage of prepayment. A combination of a part prepayment with a marginal EMI hike could sometimes work out as an ideal option, if funds are available to do so.

  • Loan Refinance

Loan Refinancing is replacing your existing loan, with a new one, under fresh terms and conditions. When interest rates rise, switching over to a lender who is offering a reduced interest rate, could serve to be a good deal. For a fee, you could switch over from a fixed to a floating rate, or vice versa. Many lenders are more than happy to attract borrowers by lowering their interest rates. However this process does not come easy. Be ready for a lot of paperwork along with foreclosure charges, and processing fees. Also take into consideration 2 to 3% penalty which the previous lender would impose.  Despite the penalty, if the new lender’s interest rate works out cheaper, it is worth a consideration.

Points to Remember

Under current economic conditions and inflationary situations, borrowers could probably expect to see more interest rate hikes. Whatever the option you choose, the following key points must be kept in mind.

  • Avoid utilizing the money that has been set aside or has been invested, for goals such as marriage, retirement, children’s education etc., to prepay your loan.
  • The basic thumb rule is to keep the EMI within manageable limits. If you have requested your lender to increase the EMI ensure you would be able to service it.
  • Interest rates may increase or decrease depending on the market direction. So cater to such rate changes in your financial plan, so that you are not caught off guard at any time in the future.
  • Always choose an option that you are most comfortable with, and not because, your lender, colleagues or friends have suggested you to do something. Remember it is your loan, and the responsibility and the cost of the loan finally fall on you.

*Featured Image: Pixabay