Are you still paying a high interest rate on your home loan?

As you would know, starting April 1, 2016, banks now use a new method of calculating the interest rates to lend. This new method is referred to as MCLR or Marginal Cost based Lending Rate.

How does it work?

So, now banks have a menu of interest rates based on the period of loan you want to opt for.

These periods are:

• 3 months
• 6 months
• 1 year
• 2 years

and so and so forth.

For every such period the bank will declare an MCLR, a so called base rate.

The bank will then add a spread or its margin to that MCLR and offer you a loan at that rate.

Interest Rate = MCLR + Spread / Margin

So for example, if the 1 year MCLR of SBI is 9.15%, it will add its spread / margin of 0.25% and offer you a home loan at 9.40%.

Get it!

Yeah, but how is that better than what I already have?

Good question! MCLR rates are lower compared to the rates which are based on older methods such as Benchmark Prime Lending Rate (BPLR) or Base Rate (BR).

For example, BPLR driven rate today is around 12% to 14% and a BR driven rate is in the range of 9.5% to 11% for a home loan for 20 years.

In contrast, the MCLR driven interest rate as offered by SBI is 9.4%. The simple conclusion, today MCLR is the the cheapest interest rate on offer. (Update on Jan 2, 2017: SBI and other PSU banks have slashed their MCLR rates by 0.9% and is now below 8%).

But remember there can be a downside to it.

What is the downside to switching to MCLR?

MCLR driven rates will be reset periodically. For example, in case of SBI, the home loan rate would be reset every year.

As a matter of fact, this is a common characteristic of all floating rate loans.

As long as the interest rates are going down, you would benefit by paying a lower EMI or reducing your loan repayment period.

But once, the interest rates start going up, you could be taken for a surprise. The EMI could rise, the loan repayment period could go up (if EMI is same) or both.

I am paying 11.55% interest rate on my home loan. What should I do?

Let’s do the numbers. You have a 15 years left to repay the loan and your loan outstanding is Rs. 20 lacs.

At 11.55%, your EMI is Rs. 23,427.

At 9.4%, your EMI would be Rs. 20,764.

The difference is Rs. 2,663 or 13% of the lower EMI.

Without a doubt, switch your home loan to a lower rate. The difference in rates is huge. Not to forget, money saved is money earned.

In reality, the EMI amount doesn’t reduce. The tenure of the loan reduces, which is equally good.

Remember though that there could be a cost of switching. The bank could levy a 0.5% to 1% fee for switching. The fee is on the outstanding loan amount.

So, if you have an outstanding loan of Rs. 20 lacs, the switching fee would be in the range of Rs. 10,000 to Rs. 20,000.

In your case, it is still a good deal to pay the fee and switch the loan to a lower cost.

I guess it makes total sense. How do I go about it?

Talk to your bank and tell them that you are interested in switching your loan to a lower rate. Understand the fees that will charge as also the new interest rate they have to offer.

You will have to fill up a switch form and a sign a new agreement.

If you plan to change your bank, there could be additional costs with respect to agreeemment registration and stamp duty. Know these costs in advance before you make the switch.

Can I switch my loan to HDFC or Tata Capital?

I suppose you mean HDFC, the Housing Finance company and not the bank. Both HDFC and Tata Capital are Non-Banking Finance companies.

They reference the Retail Prime Lending Rate to decide their interest rates. Unlike banks, they are not bound to calcualte or base their interest rates on MCLR.

No doubt the market is competitive and the interest rates would be offered at competitive levels but it is good to know the difference.

Besides, as I mentioned a while ago, there could be additional charges to switch from one institution to another. Unless, you are getting a benefit bigger than the costs, switching may not make sense.

So consider the facts of your case before you make the switch.

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Between you and me: Are you switching to MCLR? Do share your experience here.