The Reserve Bank of India's (RBI) increase in the repo rate by 25 basis points to 5.50% will lead to higher borrowing costs for borrowers with floating rates. However, it remains unclear exactly how banks will apply this increase to their customers.
Clients can choose one of two options: either maintain the original loan term and increase the monthly installment (EMI), or keep the current EMI amount and extend the repayment period. Both options may be offered by banks, but the question arises as to which is more advantageous for the borrower.
For borrowers with financial capacity, a higher monthly payment is usually the more economical choice. This is because extending the loan term can significantly increase the total interest paid over the entire loan period. Nevertheless, for those with a limited monthly budget, an increase in EMI might create additional financial difficulties.
When a floating-rate mortgage becomes more expensive, borrowers generally have three paths: accept a higher EMI and maintain the original term, extend the term to keep the EMI roughly unchanged, or use a combination of both approaches. In the first option, the monthly payment will be higher, but the debt will be repaid within the set timeframe. The second option may provide immediate relief to the family budget, but the loan will remain outstanding longer, and interest will accrue during this extended period.
Adhil Shetty, CEO of BankBazaar, noted that whether the EMI amount increases or the loan term is extended for mortgage borrowers depends on the lending institution. Floating-rate loans linked to the repo rate are typically reviewed over several months. Many lenders prefer to extend the loan term to keep the EMI constant, which seems simple but turns out to be more costly over time.
An example shows that for a home loan of 40 lakh at an interest rate of 7.5% over 25 years, the monthly payment is approximately 29,559 rupees. If the interest rate rises by 25 bps to 7.75%, the EMI will increase to approximately 30,213 rupees, representing a monthly increase of 654 rupees. If the high interest rate persists for all 25 years, the total interest paid will rise from approximately 48.68 lakh to 50.64 lakh, an increase in interest burden of about 1.96 lakh rupees.
Suppose, after the rate hike, the borrower does not want to increase their EMI, and the bank instead extends the repayment period. This may simplify monthly budget management, but the borrower will have to continue paying interest for a longer time. For instance, with a loan of 50 lakh, a monthly EMI increase would be around 817 rupees. However, if the term is extended, the loan will need to be paid off over additional months or years, meaning more money will ultimately be paid on the loan.
Shetty advised borrowers to clarify with their lender exactly how the interest rate change will be applied, and also to consider making occasional prepayments. He added that small, regular early payments can help limit additional interest expenses.