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Bank cuts rates, here's why your EMI won't change

Last updated on: September 18, 2009 16:19 IST
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Every time you hear the news about an interest rate cut you would heave a sigh of relief thinking that the next month you might hear the rate change from the bank and your total interest outgo will reduce in the form of reduced loan tenure!

Ideally, the EMI (equated monthly installment) stays constant, divided equally across the loan tenure and changes in rate cuts are most often reflected only in the form of a reduced or increased tenure as the case maybe (on the reduction or hike of interest rate, respectively) rather than any change in the actual EMI paid out in a month.

Of course, there are exceptions to this general pattern like in the case of a person having a loan tenure that goes beyond his age of retirement. In such specific cases or in isolated cases where the customer specifically requests the bank, there might be changes to the actual EMI, else the loan tenure increases or decreases as per the hike or reduction in interest rate at that point in time.

This just means that a slash in interest rate will reduce your interest outgo and you will close the loan at an earlier date compared to the previous scenario.

Coming back to the subject of when the interest rate change actually reflects in an existing customer's repayment record, well the truth is most banks do not immediately pass on the benefits of the interest rate cuts to its existing customers.

So your loan tenure and hence the current interest outgo will be the same and will not change probably until the beginning of the next quarter.

At the end of the day you will be wondering why and how your bank has not passed on the interest rate cut on your home loan yet, or fear what repercussions it might have on your long term budget and about the best option available to you to minimize the impact.

Read on to find out the truth about how change in interest rates work and why a change in rate cut doesn't always mean immediate lower loan tenure.

How change in interest rates work

The trend of offering lower interest rate on home loans is not a secret, at least in India. Whenever there is a shortfall in selling home loans or during festive seasons, banks line up to announce home loans at cheaper rate of interest. The idea is to attract maximum new customers at a lower rate of interest.

The new customers will definitely stand to benefit here but at a floating rate of interest the cheap offer just means an increase in interest rate is only round the corner probably till the period mentioned in the 'reset' clause on your agreement.

This 'reset' clause is the same reason why the same rate cut for new customers has not been applied to you, an existing customer. So what is this 'reset' clause all about?

'Reset' clause and how it could affect you!

Basically there are two aspects to consider when banks decide to pull up or push down their interest rates for its home loan customers. One, the exact percentage of interest rate cut or increase; and two, the reset clause.

A part of your loan agreement, the reset clause is the actual time period required by the bank from which the rate cuts or hike will be implemented. The rate reset clause could be monthly, quarterly, half-yearly or even yearly.

This means that if a rate cut is announced say sometime in March in the current year for a loan taken by you last November and your agreement mentions about a quarterly reset clause then the next reset dates will be made only in November, February, May, and August.

Of course, this will vary according to the loan conditions. Hence the benefit of the rate cut on interest announced in March will be reflected in your loan repayment tenure only from the month of May and not in March.

Moreover, the rate cut benefit will accrue on the principal outstanding from May and not March. For instance, if you have an outstanding loan amount of Rs 10 lakh (Rs 1 million) say in March and Rs 9.50 lakh (Rs 950,000) in May, the new interest rate will apply only on Rs 9.50 lakh.

But why a 'reset' clause is required at all?

The reset clause is required by the banks for ease of calculation and to maintain a confidence in the process. Consider the chaotic scenario where the interest rates on millions of rupees sanctioned in the form of loans are reset on any random day!

The specific time mentioned in the reset clause to adjust the change in interest rates at regular intervals will help the lender and the borrower ensure an orderly calculation, disbursement, payment and collection.

What can you do to minimize the impact?

Unfortunately, there is not much you could do as a borrower as far as the rate cuts are concerned. In most cases, your loan agreement will not allow you to negotiate on the rate cuts.

Also the banks do not engage in negotiation with the borrowers on this point as their specific products have a specific reset clause. Probably the one best thing for you to do is negotiate with your bank to reset the clause to every quarter if your agreement has mentioned about a half yearly or in worse cases an annual reset clause.

This way you can save the money paid as interest for your loan.

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