Higher EMI or longer tenure? Go by your financial wherewithal, say experts

Currently, a floating-rate loan appears a better bet than a fixed-rate peer

On August 18, 2023, the Reserve Bank of India (RBI) issued a circular titled “Reset of floating interest rate on equated monthly instalments (EMIs)-based personal loans”. Experts say that the latest rulings will make the resetting of rates more transparent and allow greater choice to borrowers.  

Give options to borrowers

Earlier, when the repo rate went up, banks would increase the tenure. When the headroom for increasing the tenure got exhausted, they would hike the EMI. All this would happen automatically.

The RBI has now made it mandatory for banks to ask borrowers which of the three options they prefer: higher EMI, longer tenure, or a combination of the two. 

“Many borrowers, who have the financial wherewithal, can now opt for an increase in EMI so that they are able to pay off the loan within the stipulated tenure and save on interest cost,” says Adhil Shetty, chief executive officer (CEO), BankBazaar.

A higher EMI, however, means less financial flexibility. Says Anuj Sharma, chief operations officer, India Mortgage Guarantee Corporation (IMGC), “The higher monthly burden would impact free cash flow and the borrower’s ability to invest for other goals.”

Elongating the tenure means more cash in hand, and greater flexibility to spend or invest, but results in a higher interest cost. Borrowers must look at their financial ability when making a choice.

Option to switch to a fixed-rate loan

RBI has made it mandatory for banks to offer borrowers the option to switch to a fixed-rate loan whenever interest rate is reset.

Currently, only a handful of lenders offer fixed-rate loans. Pricing the risk of a fixed-rate loan over a 20-30-year tenure is difficult.

To factor in this risk, fixed-rate loans are expensively priced. “Their interest rates are at least 2.5-3 percentage points higher than that of floating-rate loans,” says Sharma.

Fixed-rate loans have their benefits. “They offer peace of mind. Borrowers know that their monthly outgo will remain constant and they will be able to repay the loan by a fixed date,” says Sharma. However, remember that lenders are allowed to charge a prepayment fee in these loans.

Experts currently favour sticking to a floating-rate loan. “Why lock into a fixed-rate loan when interest rates are on the higher side? Moreover, they could start descending in a few months,” says Shetty.

The fixed-rate option should be examined when interest rates are near the bottom of the cycle. “Even at that point, borrowers should do detailed calculations to see which of the three options is most attractive: staying in the floating-rate loan and prepaying; refinancing and moving to a lower-cost floating-rate loan; or moving to a fixed-rate loan that is 2.5-3 percentage points higher.”

The repo rate has gone up by 250 basis points in the current cycle. While loan rates of existing borrowers have gone up by the same amount, rates on new loans have increased by a lesser amount as several banks have reduced the spread on their loans. Borrowers (especially those on loans linked to older benchmarks) must examine the option to refinance.

Few borrowers allow their loans to run the full 20-year course. “Most prepay within 7-10 years. Therefore, it may not make much sense to pay a much higher rate of interest if you are planning to prepay and pay off the loan early,” says Deepesh Raghaw, a Securities and Exchange Board of India or Sebi-registered investment advisor.

In the case of a fixed-rate loan, check whether it is fixed for the entire tenure. “Many such loans have a fixed rate for only the first few years,” says Raghaw.

Make simple account statement available

The RBI has asked banks to make a simple account statement available at the end of each quarter. This statement must include the following information: principal and interest recovered to date, EMI, number of EMIs left, and the annualised rate of interest or the annual percentage rate for the entire loan tenure.

“The RBI is basically saying that the key terms and conditions of a loan should not be hidden in the fine print,” says Shetty.

Raghaw suggests that borrowers check their statements regularly and stay informed about their loan’s key parameters.