Thursday, September 22, 2011

Effect of interest rate increase on loan EMI

RBI has increased the repo and reverse repo rates several times in the past one year and the indian banks and NBFCs have been quick in passing on the higher interest rates to their existing loan customers. With recent interest rate increases, one wonders what is the impact on the EMIs (the monthly installments) or the tenures of the loans, specially big ticket loans like home loans.

To take an example: The EMI per lakh (100,000) for a duration of 20 years and interest rate of 10.00% would be 966. If the interest rate goes up by 0.25%, the EMI will go up by 16 to keep the same tenure of 20 years. So, to repay the loan of 1 lakh in 20 years, the EMI increases to 982 at 10.25%. Usually banks will not increase the EMI, but will rather increase the tenure of the loan and keep the same EMI. In that case if the interest rate goes up by 0.25% and the EMI remains the same at 966, the tenure of the loan will increase by 14 months. So, the loan which was originally for 20 years will last now for 21 years and 2 months.

This can have huge implications for home loan borrowers with recent large increase in interest rates. Let's take a typical example of a home loan of 30 lakhs (30,000,000) for a duration of 20 years.

If one had got the loan at 9%, the EMI would have been 27,000. If the rate has now gone upto 10% and the borrower wants to keep the same EMI, the new tenure will be 26 years and 2 months! If the rate instead went upto 10.5%, the new tenure with the same EMI will be 34 years and 3 months!! If the rate went all the way upto 11%, the borrower cannot pay off the loan with an EMI of 27000, he has to increase the EMI. If the borrower wants to keep the same tenure i.e. 20 years, the new EMIs would be 28980 for a rate of 10%, 29960 for a rate of 10.5% and 31000 for a rate of 11%. You get an idea! You can always ask your bank for what would be the increased EMI if you want to keep the same tenure. Or what would be the increased tenure with the same EMI.

Given a choice, should one opt for increase in EMI or increase in tenure of the loan? Usually if one can bear the burden of the increased EMI, that leads to lesser total outgo of money over the duration of the loan compared to when the tenure of the loan is increased. If you can afford it, go for a higher EMI.

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