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Financial Planning

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Rising Interest Rates - What Should You Do?

Rising and falling interest rates are expected in every economy. However, it is obvious that it does not affect us if we have taken a fixed interest rate loan. But suppose, if we have taken a floating interest rate loan and the interest rates are on the rise, it means our cost of borrowing will increase. In this case, we can choose to exercise multiple options instead of paying a higher interest amount.

The options are as follows -

a. Increasing the loan tenure and keeping the EMI constant

When interest rates rise, a sudden rise in EMI could be quite a pinch, especially for -

i. Individuals in tight financial conditions;
ii. Individuals with more than one debt; and 
iii. Individuals nearing retirement. 

At such times, keeping the EMI constant and increasing the loan tenure works out as an ideal option. Lenders accommodate the interest rate increase in the increased loan tenure and retain the monthly outflow at the same level. However, keep in mind that by doing so in the long run, you end up paying more interest for your loan. Some lenders may not permit an increase in loan tenure beyond a specific term, especially for those nearing retirement. So, check with your lender on the possible way out.

b. Increasing the EMI, with the same loan tenure

For those who can afford it, go for a higher EMI while maintaining the same loan tenure. This is because, by increasing the EMI and retaining the same loan tenure, though the monthly outflow will become higher, the total cost of the loan will work out to be much lesser. The increase in EMI must be within your financial capacity to make payments every month.

c. Loan Prepayment

For many borrowers, loan prepayment could be the last option in times of high interest rates, as it primarily depends upon the liquidity position. When going in for a prepayment, remember to check on the prepayment charges the lender would quote. Consider prepayment only if the cost of prepaying the loan works out to be much lesser than the rise in interest rate. 

Loans could also be part prepaid. By doing so, the loan principal value comes down, thus reducing the total interest amount you’ll pay. 

The EMI would reduce, or at least, the same EMI would remain even after an interest rate increase. 

Some banks may not even charge a penalty for up to a certain percentage of prepayment. 

A combination of a part prepayment with a marginal EMI hike could sometimes work out as an ideal option, if funds are available to do so. 

Now comes the big question - when is the best time to prepay a loan? 

This question is quite relevant for home loans, as the amounts (and thus, the interest) involved is very large. 

Towards the end of a loan, you are mostly paying the principal and very little of interest. Whereas towards the beginning of a loan, you are mostly paying interest, and very little in terms of repaying the principal. 

Therefore, if you repay the loan towards the beginning, you would be saving a lot more on the interest than if you repay the loan towards its end. 

d. Loan Refinance 

Loan Refinancing means replacing your existing loan, with a new one, under fresh terms and conditions. When interest rates rise, switching over to a lender who is offering a reduced interest rate, could serve to be a good deal. At a charge, you could switch over from a fixed to a floating rate, or vice versa. 

Many lenders are more than happy to attract borrowers by lowering their interest rates. However, this process does not come easy. Be ready for a lot of paperwork along with foreclosure charges, and processing fees. Do take into consideration the penalty which the previous lender would impose. In spite of the penalty, if the new lender’s interest rate works out cheaper, it is worth a consideration. 

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