Opt for refinancing only if potential savings in the long run seem significant.

Over the last few quarters, the Reserve Bank of India (RBI) has lowered the repo rate by 0.5%, which has been followed by rate cuts by banks and lenders. This has resulted in lowered Home Loan rates for borrowers. Nitish has a Home Loan of Rs. 2 crores that he availed at an interest rate of 11.25%. The tenure of his loan is 20 years. After making payments for seven years, he wants to refinance his Home Loan for the remaining tenure at an interest rate of 10.50% to take advantage of the falling interest rate cycle. Will this be a wise decision? Should he opt for a Balance Transfer?

Many existing borrowers would explore switching over their Home Loan to another lender in order to take advantage of the new rates and lower EMI. If done properly, refinancing can be very beneficial. However, before Nitish goes any further, he needs to do a thorough cost benefit analysis. It is important to time the loan refinancing in such a way that saving on interest payable is maximised.

Nitish will find switching lucrative as he has covered only seven years of his loan tenure. This means a large portion of his principal is outstanding, as his EMI is mostly made up of the interest component. As time goes by, the interest component will come down and the principal component will go up.

Therefore, instead of making the switch decision by only considering the interest rate differential, Nitish must make sure that he factors in all the costs (including pre-payment charges and processing fee of the new loan) and the hassles of repeated paperwork that goes into Balance Transfer, when computing the potential savings. Needless to say, refinancing is a profitable move only when the potential savings in the long run are significant.

Smart Things to Know

  1. Credit risk funds are a category of Debt Mutual Funds that invest at least 65% of their portfolios in securities with less than AA rating.
  2. These funds have the potential to generate high returns as they take higher credit risk by investing in lower-rated paper which gives higher interest.
  3. If the rating of a security moves up, they offer the benefit of capital gains. However, in case of downgrades there can be a capital loss.
  4. Due to nature of the underlying investments, these funds also carry higher liquidity risk and higher risk of default.
  5. It is a suitable investment for someone with a medium to long-term time horizon and higher risk appetite.