Five tips to tackle rising interest on your loans

Interest rates in India are once again on the rise after cooling down a little in the first half of the current calendar year. The interest rate of the yield on benchmark 10-year government of India bond is up by 25 basis points in the last three months after falling by 50 basis points in the preceding three months. 

The yield on 10-year treasury bonds is currently at around 7.2 percent compared to a one-year low of 6.95 percent in the middle of May this year. The rise yields on the short-term rate tenure bonds have been even steeper at 35 basis points. The yield on 2-year treasury bonds has shot up 7.13 percent from 6.78 percent in May this year.

This has resulted in a creeping rise in interest rates on all kinds of loans - from home loan and car loan to personal and business loans. The rise in interest rate has been much steeper for high-risk and unsecured loan products such as low-income housing loans, personal loans and consumer durables loans. 

Higher lending translates into higher monthly payments on EMIs, higher loan repayment tenure or both. Beyond a certain threshold, higher EMIs on loans start hurting household budgets given that most middle-class families have some kind of loans on their books.

Most experts see a further rise in interest rates given the recent rise in inflation and the expectation of a further rise in food prices due to poor monsoon rains this season. 

Besides, the benchmark interest rate has risen much faster in the United States and the US Federal Reserve has hinted at a further hike in its Fed fund rate to cool down inflation. 

Higher interest rates in the world’s biggest economy translate into higher interest rates across the globe.

The interest rate on 10-year US treasury bonds is up by nearly 85 basis points since April this year. Higher interest rates in the US also lead to currency depreciation in emerging markets if central banks in these economies try to resist raising interest rates. Currency depreciation in turn feeds into inflation through higher energy and commodity prices, resulting in higher inflation and interest rates in future.

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That’s why it’s important to take the right steps to protect your and your family's finances from the higher interest on loans. Here are five simple tips to help you tackle the risk of higher EMIs in a breeze.

1. Calculate your EMI vulnerability index. As a thumb rule, a person with a higher EMI vulnerability index needs to be more proactive in managing or optimizing the interest and loan repayment burden in their finances. However, you don’t need to lose sleep and spoil your health thinking about interest rates. 

The first step is to calculate your loan servicing ratio or LSR. Add up all your income and cash inflows including imputed savings on house rent if you are living in the house that you have bought on loan. Now calculate the combined monthly EMIs on all your outstanding loans. Divide your monthly income in hand/cash inflow with the total EMIs to get LSR. 

Your finances are pretty insulated from a sharp rise in interest rate if your LSR is 3X or higher. 

However, you and your family need to sit down and have frank discussions about income and expenses if your LSR is closer to 2X. And you are in a red zone if your LSR has now declined to 1.5X or lower. You need to take drastic measures to raise the LSR either by reducing EMIs or raising the family’s income.

2. Convert your existing loans to lower interest rate slabs. Reducing interest rates on big-ticket loans such as home loans is a sure-shot way to cut your EMIs and create financial headroom for your family. Most banks and housing loan companies offer the option of loan conversion to lower interest rate slabs for a one-time conversion fee. Talk to your lender right away and explore the possibility of reducing interest on your home loan. If the lender agrees you can use it to reduce your monthly EMIs, reduce the loan repayment tenure or do a mix of both.

3. Retire high-cost personal and credit card debt. Consumption-related personal loans and unsecured loans such as credit card debt carry the highest interest rate and can become a big financial burden if interest rates stay higher for longer. 

If high indebtedness and rising EMIs on loans are giving you sleepless nights then tackle the debt with the highest interest rate first. This means prepaying high-cost personal and credit debt. 

You can do this either by dipping into your retirement savings, borrowing from family or friends and even taking out low-cost secured loans. If the loan amount is big you can even explore the possibility of selling some of your assets such as real estate, jewellery, stocks and mutual funds to retire these high-cost loans.

4. Switch to loan against property. Interest on loans against fixed assets such as a house, land, commercial property and gold jewellery is far lower than that on personal loans and vehicle loans. Banks also provide low-cost loans against financial assets such as shares and debentures, life insurance policies, mutual funds units and bank fixed deposits among others. 

If you and your family are sitting on these kinds of physical and financial assets then you can leverage them to get low-cost loans and use the proceeds to retire high-cost debt. This could translate into big monthly savings in EMIs and lower loan repayment tenure. Here the top-up loans against your existing home loan should be the first option followed by a loan against property followed by a loan against LIC policies and gold loans.

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5. Take an 'interest-free loan' from your provident fund. A premature withdrawal from your provident fund account (PPF) is a good way to stay from the worries of high-interest rates. 

If you have accumulated substantial savings in your PPF account then apply for a premature withdrawal but then treat it as a loan that you have to repay. 

Have a concrete plan to top-up your PPF account in future so that your savings in PPF are restored to the amount that was before you dipped into it. This will ensure that you don’t lose out on compounding benefits and end up with a far lower retirement kitty than otherwise. One way to do this is to start topping up your PPF account with the amount that you have otherwise spent on loan servicing if you had borrowed the money from the bank. For example, if you withdraw Rs 10 lakh from PPF to buy a house then top-up your PPF account with around Rs 10,000 per month, which is the EMIs on a home loan worth Rs 10 lakh. This helps you to kill two birds with one stone.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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