There are many ways to lose money when you
refinance and it’s important to think through the entire process, weigh
the pros with the cons and then decide
Loan switching or refinancing is one of the most
common things that customers think about in environments where interest
rates are dynamic and it can lead to customers getting significant
benefits however the same needs to be done smartly. If one is
considering refinancing your loans, it's probably because you think you
can save money, especially now when interest rates have come down in the
past one year. Well, your thinking is right on target and it goes to
prove that you are a smart customer.
There are many ways to save money through
refinancing - including lowering your interest rate and shortening the
term of your loan. But unfortunately, with refinancing fees, there are
just as many ways to lose money when you refinance as well and it’s
important for the customers to think through the entire process, weigh
the pros with the cons and then decide if this is something that is
worth their time.
Loan switching is a personal decision that should be
based upon not only current monthly savings but also ones short and long
term plans. Add to that the effort required in loan switching, and the
hidden charges and difficulties that might come your way when bank does
everything in their power to retain a ‘good’ customer.
To determine if loan switching is right for you, read on to learn more about how you can save and lose money by refinancing.
Ways You Can Save Money by Refinancing
#1 - Getting a lower interest rate
In general, refinancing for a lower interest rate is probably going to save you money, both on a monthly basis and over the term of your loan. The same can be easily explained with an example: A is running a floating rate loan at 10.5% which had increased due to the upsurge in interest rate, at that point of time he was paying an EMI of Rs 998 per lakh.
However, now that interest rates have come down, this
loan can be refinanced at 9.5% (current market interest rate) and the
EMI would reduce to Rs 932 per lakh. This would lead to a saving of Rs
66 per lakh of loan being run by A. Now if one was to look at the saving
over the entire loan amount and over the entire tenor of the loan, this
would work out to a significant sum leading to a direct immediate
benefit for the customer.
However, there are a few caveats. Even with a lower
interest rate, borrowers need to consider certain loan switching costs
(eg processing fee when switching to a new bank, certain levies by the
old bank, etc.) and make sure the savings from the lower interest rate
will outweigh the refinancing costs.
#2 - Switching to a shorter-term loan
When paying off a longer-term loan, you might feel like you're saving money because your monthly payments are low. However, this thought process is a fallacy as one is actual paying a higher quantum of interest as it is over a much longer term, sometimes much longer than it really needs to be. Once can definitely save more money in interest by paying that same loan off over a shorter term.
In addition, it’s also possible that the banks are
willing to give a better interest rate for a shorter tenor loan as well,
as the bank would believe that it represents a significant shift in the
risk profile of the customer. As a thumb rule, the shorter the tenor of
the product, the lower would be the quantum of interest being paid out.
However, one point of caution here is that
refinancing to a shorter term-loan with a lower interest rate would only
be advisable for a borrower if they're comfortable with the higher
payment, as this would lead to a higher monthly outflow but since the
loan would be paid off earlier due to the shorter tenor the overall
interest outflow would be lesser.
#3 - Switching from a floating rate loan to a fixed rate loan
When you have a floating rate loan, your payments fluctuate as interest rates go up and down, based on a market conditions. This can be great when interest rates are low, but extremely difficult when the interest rates rise. In an increasing interest rate scenario its often seen, that since customers do not have the comfort of paying a higher EMI, they tend to increase tenor of the loan, which is the worst possible thing that can happen as one has effectively increased the interest outflow. Another point to consider, is that if the same happens early in the history of the loan, then the burden is higher as the construct of the EMI payment is such that in the initial years of a longer tenor loan most of the EMI ends up going towards the interest component. Now if the rates go up, then effectively one has already paid a high quantum of interest, and the double whammy of the loan being extended also hits them.
If the customers feel that they are unable to manage
this volatility they can switch to fixed rate loans which are slightly
more expensive than a floating rate loan on a current date but by
definition remain fixed even in an upwardly moving interest rate cycle.
As a final note on this topic, however here's
something to mull over: With rates currently coming down, do you think
they could go any lower? If you do, then stick with a floating rate
loan. if you don't, then a fixed rate loan is the best money-saving
option for you.
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