Explained: Why it may be a good idea to use your FD to pre-pay part of your home loan

In a surprise move, RBI on Wednesday (May 4) announced a 40 basis point hike in the repo rate. While repo rate is the rate at which RBI lends to commercial banks, the move is set to make borrowing expensive. The news came out of the blue, and as the shock hit investor sentiment, the Sensex lost over 900 points between 2 pm and the close of the market. The benchmark index closed the day at 55,669, sharply down by 1,306 points or 2.29 per cent.

What was the major concern driving the RBI?

Inflation has been a big concern, and continuing high food and fuel prices forced the RBI to call a mid-term meeting of its Monetary Policy Committee (MPC), where it was unanimously decided to raise the repo rate by 40 basis points to 4.4 per cent.

It was also decided to raise the cash reserve ratio (CRR) by 50 basis points to 4.50 per cent to suck out liquidity and bring down the elevated inflation.

But what fallout can this decision have?

As India emerged from the Covid-19 pandemic, the economy — which is largely consumption oriented — started to witness the return of demand — for housing, white goods, travel, etc. While the decision to hike rates is mostly to curb inflation, a spike in rates and withdrawal of liquidity may also slow down the pace of the uptick in the economy, and put brakes on the revival process.

If consumption is impacted, it may in turn hurt the capacity utilisations for companies across sectors, and may even defer India Inc’s investment plans.

Should individuals worry about the rate hike?

The 40 basis point hike is not as much of a concern as is the possibility of many more rate hikes this year, and the pace at which the RBI goes about doing so. It remains to be seen whether RBI raises rates by a total 50-100 basis points this year, or whether the hike is much greater — in the range of, say, 150-200 basis points.

In the second scenario — of rate hikes up to 150-200 basis points — existing home loan customers, and even prospective home buyers, may be significantly hurt. EMI-based buying of consumer durable items by households may also be impacted, thus hurting consumption in the economy.

To what extent specifically can your EMIs get impacted?

A 40 basis point hike along with the increase in cash reserve ratio means that banks and housing finance companies may raise rates by more than 40 basis points immediately. So, if they were to raise the rates by, say, 50 basis points from 7 per cent to 7.5 per cent, the EMI on principal outstanding of Rs 50 lakh for 15 years will go up from Rs 44,941 to Rs 46,350 – a jump of Rs 1,409 in monthly EMIs if the tenure is kept constant.

However, if the rates were to rise by, say, 200 basis points by the end of the year, the customer would see her loan rate going up from around 7 per cent now to 9 per cent by that time. In that scenario, her EMI for the same loan would jump to Rs 50,713 — an increase of Rs 5,772 per month. This would be a big dent for individuals who will witness a decline in their incomes during Covid.

In case the borrower cannot, or does not want to, go for a hike in EMI, she would see her loan tenure jump from 180 months (15 years) to 191 months in case of a 50 basis point hike, and to 240 months ( 20 years) in case the rates go up by 200 basis points during the year.

Car and two-wheeler sales have already been hit by costs of vehicles and a fall in household incomes in rural and semi-urban areas. The hike in interest rates will further impact the affordability of a vehicle — also because fuel is so expensive now.

What should existing home loan customers do?

As post-tax fixed deposit earning for an individual in the highest tax bracket currently stands between 3.1 to 4.1 per cent, existing home loan customers would do well to utilise some of their fixed deposits to pre-pay a part of their home loan.

While the rates still continue to remain relatively low, and may rise over the next year or two, existing home loan customers should look to raise their EMIs so that the impact of subsequent rate hikes over the next 12-18 months has a reduced impact on the EMI and tenure of the loan.

What about investments? How does debt stack up against equity?

As a result of the low interest rate environment, most fixed deposit instruments have been earning an interest rate between 4.5 per cent and 6 per cent for investors depending upon tenures; However, as a result of the high inflation, the real interest earning has been negative.

For those in the highest tax bracket, it makes even less sense to invest in fixed deposits as the post-tax-return would stand between 3.1 per cent to 4.1 per cent, which is significantly lower than the inflation rate of 7 per cent.

If the fixed deposit or a small saving instrument is earning 6 per cent, and the inflation is 7 per cent, then on a net basis the real interest income is negative (nominal interest rate – inflation). Most small savings schemes are now generating negative real rates of interest; Only PPF (7.1%) and Sukanya Samriddhi Yojana (7.6%) are generating an interest income higher than the inflation rate now.

While equity investment can only beat inflation, investors who still want to stick with pure debt products should not lock in for long durations, but rather go for short duration products.

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Some investors can also look at corporate deposits offering relatively high interest rates, but they must seek professional advice before going for any specific offering, and weigh their rating and risk.

However, investors should look more towards equities, because any financial instrument must serve the purpose of growing your money over a period of time. With inflation currently around 7 per cent, any income of less than 7 per cent net of taxes, actually makes you lose money.

Financial advisors say that conservative investors will have to bring equity into their portfolio in some form, and will have to be ready to carry some risk and live with some volatility. Investors need to improve their basket of asset allocation and will have to consider mutual fund offerings such as conservative debt hybrid, balanced advantage funds, and equity saving schemes (that invest in equity, debt and arbitrage securities). Investors need to understand that higher returns can only come from equities and it also leads to better tax management.

In fact, a decline in the markets on account of interest rates should be taken as an opportunity to invest for the long term.

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