Should you refinance your home loan?

Good news for homeowners! The Reserve Bank of India (RBI) on Tuesday, April 21, 2009 pressed local banks again to pass on lower rates to consumers, and there were some signs that lenders may follow suit. This means that your home loan may become cheaper soon. However, if you feel that the rate of interest offered by lenders on new home loans are much lower than that of your loan, you may consider refinancing your home mortgage.

Here is a guide to help you decide on whether you should refinance your home loan or not. Refinancing your home loan may save you a lot, if you consider all the reasons to do it.

Reasons to refinance your home loan

There are several reasons to refinance your home mortgage, and knowing when is the right time depends on your particular situation. Refinancing your home mortgage allows you to obtain a new loan to pay off your existing one. Both loans are secured by the same property.

Lower Your Monthly Payments

The most common reason homeowners refinance their mortgage is to lower their monthly payment. If interest rates drop low enough below your current rate, you could save money both on your payments as well as on the overall amount of interest you pay over the life of the loan. Before you make the decision to refinance, it’s important to figure out how much it will cost you, and whether your remaining loan tenure of your existing loan is long enough to recuperate these charges.

To calculate if the lower monthly payments you will get by refinancing will be worth it for you in the long run, use the following calculation:

Take the total cost to refinance, this includes the pre-payment penalty on the principal outstanding of your existing loan as well as the amount of processing and administration charges that you need to pay for the refinance loan. Your respective lenders can provide an estimate.

Now, you need to divide the total cost of refinance by the monthly savings (your current monthly installment (EMI) amount minus your proposed new EMI). This gives you the “breakeven point”, or the number of months you will need to recover the refinance cost and start saving on the reduced interest rate on your home loan.

For example:

Total cost : Rs. 36,000
Current monthly payment: Rs. 20,000
New monthly payment: Rs.18,000
Breakeven point = Rs. 36,000 / ( Rs. 20,000 - Rs. 18,000 ) = 18 months

The example above shows that you would have to stay in your house for at least a year and a half to break even and start enjoying your savings. In other words, if you were planning on keeping your existing house for at least a year, it would be worth refinancing. Otherwise, you would need to wait for interest rates to drop further.

Change the Term of Your Loan

Lowering your monthly payment is only one reason to refinance. There are others that might make sense for you. Many a times, you have to go for the longest possible term to fit the home loan EMI to your pocket. However, with increased earnings you may decide to increase the EMI amount.

So, if you feel you can afford a higher monthly payment, you may consider refinancing to decrease the term of the loan. A shorter-term loan can help you build equity in your home quicker as the principal component in your EMI is larger. This helps you to save a significant amount of money over the life of the loan.

For example:

Following table provides you an illustration of how much you pay in interest on a Rs. 25,00,000 loan over 25 years, 20 years and 15 years loan at a interest rate of 9.5%.

Lower Loan Term Saves you Interest
Loan Term in years	25	20	15
Loan Term in months	300	240	180
Loan Amount	25,00,000	25,00,000	25,00,000
Interest Rate	9.50%	9.50%	9.50%
Monthly EMI	21,843	23,304	26,106
Total Payment	65,52,900	55,92,960	46,99,080
Total Interest Paid	40,52,900	30,92,960	21,99,080

If you have a Rs. 25,00,000 home loan for a loan term of 25 years at 9.5% rate of interest,  you pay a whooping sum of Rs. 40,52,900 in interest as compared to Rs. 21,99,080 of interest in a 15 years loan. This means by paying 16.33% lower EMI on a 25 years loan vis-à-vis a 15 year loan you pay 84.30% more in interest!

Although your payment is higher each month on a lower term loan, if you can afford it, it’s worth it. You will pay a lot less in interest and will build your home equity much faster.

Switch Loan Types

If your current loan is a fixed rate loan and you wish to take advantage of falling interest rates, you may opt to switch to a floating interest home loan. Or if you already have a floating interest rate loan and your rate is about to adjust to a higher one, or you are just tired of the uncertainty of a floating interest rates, it may be time to refinance to a fixed rate loan. (However, our personal opinion is that a floating interest rate loan would be better option considering the long term nature of home loans and the over all objective of RBI to lower interest rates.)

By switching your loan type, your monthly payment may increase, but if interest rates are on the rise, your floating rate loan could end up climbing to a higher payment in the long run.

Tap the Equity on Your Home

You build equity in your home by paying down the principal on your loan or having the value of your house increase from the time you bought it. If you have enough equity in your home, you may be able to refinance to get extra cash out. You may want to do this if you need money to consolidate your debts, pay for your children’s education, perform home improvements or make other large purchases. Depending on the interest rate you can get, it may reduce you overall monthly payments if you use the money to pay off other high cost debts such as your revolving credit on your credit card, personal loan or even your car loan for instance.

Conclusion

If you are aware, you can make excellent use of home loan refinance option to lower your monthly payments, save on interest payouts or retire your other high cost debts. So, go ahead and make a prudent use of refinancing your home loan.