Interest Rate Drops Fail to Bring Immediate Relief to Borrowers in the Form of Lower EMI Payments

Loan Reset Delays and the Misconceptions of Rate Cuts

Key Points:

• Central bank rate cuts do not immediately reset loan EMIs, as most loans are linked to external benchmarks with predefined reset intervals.
• Tenure extensions can quietly increase loan duration, resulting in higher overall interest paid.
• Rate-linked loans may not pass on rate cuts equally, with older loans and adjusted spreads affecting the effective rate.
• Interest compounding works against borrowers in the early years of a loan, amplifying the impact of rate changes.
• Top-ups, moratoriums, and restructurings can add hidden layers to loan behavior, keeping EMIs elevated or rising.
• Fees and insurance premiums can quietly inflate the EMI, unrelated to interest rate changes.
• Prepayments are crucial after rate cuts, as they directly attack the principal and can have a disproportionate effect.

Loan Reset Delays:

Read also: Correcting Credit Score Errors: A Guide to Ensuring Accurate CIBIL Reports and Optimal Loan Eligibility

• Most loans are linked to external benchmarks, with resets occurring at predefined intervals.
• If a rate cut happens but the reset date has not yet passed, the EMI will still reflect the old rate.

Tenure Extensions:

• Banks may adjust tenure instead of EMI when rates rise, keeping monthly payments stable.
• This can result in a longer loan duration and higher overall interest paid.

Rate-Linked Loans:

Read also: Missing a Single EMI Payment Can Adversely Impact Credit Profile

• Older loans, especially those linked to base rate or MCLR, tend to pass on rate cuts slowly and unevenly.
• Even newer external benchmark-linked loans may not fully pass on rate cuts, due to adjusted spreads.

Interest Compounding:

• In the early years of a loan, a large part of the EMI goes toward interest rather than principal.
• Rate changes during this phase can have a significant impact, as interest is calculated on a large outstanding amount.

Top-Ups, Moratoriums, and Restructurings:

• These changes can add hidden layers to loan behavior, keeping EMIs elevated or rising.
• Interest accumulated during moratoriums gets capitalised, while top-ups increase principal.

Fees and Insurance:

• Mandatory loan insurance premiums, escrow charges, or revised service fees can get bundled into monthly payments.
• This can result in a higher EMI, unrelated to interest rate changes.

Prepayments:

• Prepayments are crucial after rate cuts, as they directly attack the principal and can have a disproportionate effect.
• Without prepayments, rate cuts mainly reduce interest marginally, while EMI structures shaped by earlier rate hikes remain in place.

Action Items:

• Review your latest amortisation schedule to understand your loan's behavior.
• Check your current interest rate, remaining tenure, and outstanding principal against what you originally signed up for.
• Consider switching to a newer benchmark or resetting tenure downward if it has ballooned.
• Prioritise prepayments over waiting for rate relief.