Larger EMI or longer tenure?:: Business Line

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What should those without a surplus to pre-pay loans do in a scenario of rising interest rates? Rising interest rates on loans can be handled either by increasing the EMI on the loan, or extending the tenure of the loan.

To the extent possible, it is better to increase the EMI amount. This option, though it involves stretching finances in the short term, saves the borrower a substantial amount in terms of future interest outgo. The trade-off is between short-term pain and long-term gain.

An increase in tenure, on the other hand, will see the borrowers' future interest cost balloon substantially, though the EMI remains constant. In this case, short-term gain can translate into long-term pain. Consider the case of a borrower who takes a loan of Rs 10 lakh for 15 years at a rate of 10 per cent, and the rate is later increased to 12 per cent. The Table illustrates why increasing EMI is a better idea than increasing tenure.

Keeping the tenure constant and increasing the EMI resulted in a 24 per cent increase in total interest cost, while keeping the EMI constant and increasing the tenure saw total interest cost increase by a whopping 102 per cent.

The sharp spike in interest outgo with an increase in tenure happens because interest payment makes up a much higher proportion of the initial EMIs and principal repayment gets pushed further into the horizon. As long as the principal remains unpaid, it continues to bear interest.

There have been instances of banks unilaterally increasing the loan tenure instead on increasing EMI when interest rates go up. Keep a close watch to avoid getting caught by such practices, and go in for a higher EMI, if you can afford it.

Borrowers who do not have sufficient funds to pre-pay can also consider refinancing the loan, if other lenders offer lower rates. In such cases, the borrower needs to calculate whether the cost reduction benefit from refinancing is higher than the pre-payment penalty. Before homing in on a new lender, scout around for the best refinancing rates. Also, it is important to take into account processing charges, which add to the cost of the new loan.