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Should I Refinance My Existing Home Loan?

Refinancing is a process by which a borrower can replace an existing loan with another loan on different terms. Refinancing is most common in home loans and is usually done to reduce the interest rate, change the EMI payments, change the tenure of the loan etc.

Since the RBI's announcement about lower interest rates, we have received numerous queries on whether one should refinance one's existing home loan, which is at a high rate for another home loan at a cheaper rate.

Its useful to do this only if it makes economic sense, i.e., you are going to save money in the long run. But what could cost you money in this if all you are trying to do is to switch to a cheaper rate?

First of all, your existing lender knows that you might want to switch, and so creates some hurdles for you. Typically, you might be required to continue with the loan for at least 12 months before you are allowed to refinance your loan (or transfer your balance to another lender). So, check with your lender if you have met this hurdle or not.

Secondly, the original lender might charge you a penalty fee, which could be anywhere between 2%-4% of the principal amount of the loan outstanding at the time of your refinance. Example, if you have Rs. 20 lakhs still outstanding on the loan, with 15 years remaining on the loan tenure, you might be expected to pay a 3% penalty fee of up to Rs. 60,000 to exit your loan.

Finally, the new lender that you are going to for their cheaper home loan rate might charge you a loan processing fee (plus service tax) of anywhere between a minimum of Rs 5,000 to a maximum of 1% of the loan amount (depending upon whether you are self-employed or an employee).

So, the total cost to refinance comes to the sum of the penalty fees and the loan-processing fee. Using our above example, that sum is Rs. 60,000 + Rs. 5,000 = Rs. 65,000.

On the savings side, lets say you can get a loan for 1% cheaper interest rate than your existing loan. That would mean a reduction in your EMI of approximately Rs. 1,236, for a cumulative savings of approximately Rs. 121,000 over the remaining 15 years. (Not to get too technical, but for those of you familiar with the concept of present value in finance, this Rs. 121,000 is the present value of the savings that you will make over the remaining tenure of the loan.)

So, a refinancing makes sense only if you save more money on the lower home loan rate compared the penalties and processing fees that you might have to pay. In our example we can save Rs. 121,000 less Rs. 65,000 = Rs. 56,000 through the re-financing, and it makes sense to do so.

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