Explained: Why it might be a good idea to use your FD to prepay part of your home loan

In a surprise move, RBI announced on Wednesday May 4 an increase of 40 basis points in the pension rate. While the repo rate is the rate at which RBI lends to commercial banks, the move is expected to make borrowing costly. The news came out of the blue, and as the shock hit investor sentiment, the Sensex lost more than 900 points between 2 p.m. and the market close. The benchmark closed the day at 55,669, down a steep 1,306 points or 2.29%.

What was the main concern motivating the RBI?

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

It was also decided to increase the cash reserve ratio (CRR) by 50 basis points to 4.50% to suck up liquidity and bring down high inflation.

But what impact can this decision have?

As India emerged from the Covid-19 pandemic, the economy – which is largely consumer-driven – began to witness a return of demand – for housing, white goods, travel, etc. While the decision to raise rates is primarily to curb inflation, a spike in rates and the withdrawal of liquidity can also slow the pace of the economy’s recovery and stall the recovery process.

If consumption is affected, this could in turn hurt the capacity utilization of companies across all sectors, and could even delay India Inc’s investment plans.

Should individuals be worried about rising interest rates?

The 40 basis point hike is not as concerning as the possibility of many more rate hikes this year, and the pace at which the RBI is going about it. It remains to be seen whether RBI raises rates by a total of 50 to 100 basis points this year, or whether the hike is much larger – in the range of, say, 150 to 200 basis points.

In the second scenario – rate hikes of up to 150-200 basis points – existing mortgage customers, and even potential buyers, could be significantly affected. Purchase of durable consumer items by households based on EMI may also be impacted, harming consumption in the economy.

How specifically can your NDEs be impacted?

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

However, if rates were to rise by, say, 200 basis points by the end of the year, the client would see her loan rate drop from around 7% now to 9% by then. In this scenario, his EMI for the same loan would rise to Rs 50,713, an increase of Rs 5,772 per month. This would be a big blow to people who have witnessed a drop in income during Covid.

In the event that the borrower cannot or does not want to increase the EMI, he would see the duration of his loan increase from 180 months (15 years) to 191 months in the event of an increase of 50 basis points, and to 240 months (20 years) in case rates increase by 200 basis points during the year.

Sales of cars and two-wheelers have already suffered from rising vehicle prices and falling household incomes in rural and semi-urban areas. Rising interest rates will further impact the affordability of a vehicle, especially because fuel is so expensive today.

What should existing mortgage customers do?

Since after-tax fixed deposit income for someone in the highest tax bracket is currently between 3.1 and 4.1 percent, existing home loan customers would do well to use some of their fixed deposits to prepay part of their home loan.

Although rates will continue to remain relatively low and may rise over the next year or two, existing home loan customers should seek to increase their EMIs so that the impact of subsequent rate increases over the next 12 to the next 18 months has a reduced impact on the EMI and the duration of the loan.

What about investments? How does debt compare to equity?

Due to low interest rates, most term deposit instruments earn an interest rate of between 4.5% and 6% for investors depending on tenure; however, due to high inflation, real interest income was negative.

For those in the highest tax bracket, it makes even less sense to invest in term deposits, as the after-tax return would be between 3.1% and 4.1%, which is well below the inflation rate of 7%.

If the fixed deposit or a small savings instrument earns 6% and inflation is 7%, then on a net basis the real interest income is negative (nominal interest rate – inflation). Most small savings schemes now generate negative real interest rates; only PPF (7.1%) and Sukanya Samriddhi Yojana (7.6%) currently generate interest income above the rate of inflation.

Although investing in equities can only beat inflation, investors who still want to stick with pure debt products should not commit to long durations, but rather opt for short duration products. .

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Some investors may also view deposits from companies offering relatively high interest rates, but should seek professional advice before opting for a specific offer, and weigh their rating and risk.

However, investors should lean more toward stocks, as any financial instrument should aim to grow your money over a period of time. With inflation currently around 7%, any income less than 7% after tax is losing you money.

Financial advisers say conservative investors will need to bring stocks into their portfolio in one form or another, and will need to be prepared to take on some risk and live with some volatility. Investors need to improve their asset allocation basket and will need to consider mutual fund offerings such as conservative debt hybrids, balanced advantage funds and equity savings plans (which invest in stocks, debt securities and arbitration securities). Investors should understand that higher returns can only come from stocks and this also leads to better tax management.

In fact, a decline in the markets due to rising interest rates should be seen as an opportunity to invest for the long term.

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