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[city02 63]

The short answer is DEPENDS!

I was faced with an interesting choice on my floating rate loan:

Option 1: reduce interest by 1.25% by paying Rs. 18.6 k in fees

Option 2: reduce rates by 1.75% and pay Rs. 56 k in fees

I was instinctively going for the lower rate but that turned out NOT to be the correct decision.

It depends on your tenure remaining and using the MS Excel PV [present value] function!

First you need to get some data from your current bank,

[since different banks use different methods for computing EMI at the same interest rates!]

Most banks will offer a reduced tenure at lower rates but that's a very misleading way to calculate your potential benefits.

In the last year of your loan there will be very little of your EMI going to interest and mostly towards principal.

So any interest savings are tiny.

Best to ask them to fix the current tenure and show the different EMI at different rates.

Now the difference in EMI is your savings in cash flow for the remaining months.

It still needs to be discounted to the present by the new rates.

That would give you the MAX GROSS benefits you would get by switching to the lower rates.

Then you subtract the total fees to get the NET benefit.

If your tenure is < 5-6 years, your NET might be NEGATIVE implying its mostly a bad idea to switch to lower rates for short durations.

i.e., you will end up losing money by going to a lower rate!

This has a couple of major assumptions:

1. Your bank will not further hike the interest rates for the remainder of the tenure [highly unlikely for floating loans]

2. You will not prepay and further reduce your tenure and thus the benefit of lower rates

In my case the breakeven durations were 9 months for #1 above

and 19 months for #2.

I already know that floating rates will probably go up next year so the odds of remaining at the current levels [or below] are slim.

Now most of us don't carry around excel or business calculators when faced with this choice to switch.

So I tried to come up with various rules of thumb to help guide us on the spot...

Let's [for the sake of argument] classify the remaining tenures of the loans as:

1. Long term [> 10 years or 120 emi left]

2. Medium [5 - 10 years or 60 - 120 emi]

3. Short [< 5 years or 60 emi]

Now, we should only bother with the PV function if the offer meets the following criteria:

1. For long term loans, if the reduction is > 1-2% or 100-200 basis points

2. For medium terms, the reduction > 2-3% or 200-300 bps

3. For short terms, the reduction > 3-4% or 300-400 bps

Since I fell into the first category, it made sense to further examine the deals based on costs of switching.

Let me know if you come up with a better/simpler heuristic so we can all benefit when deciding.

[commonman 228]

While considering the break even point, also consider two more possible alternatives provided there are no partial pre-payment penalty,

1. Making a pre-deposit of Rs.18 K in the existing loan account

2. Making a pre-deposit of Rs. 56 K in the existing loan account

In certain conditions, the above options may get better results.

As for the break even point, most people take home loan for 20/25 year period. So, it could definitely make sense to shift if the balance period of loan in 10/15 years.

[city02 63]

Agreed, but when I mentioned 'total fees' above I meant to include ALL the costs of switching over not just the fees for the new loan.

This would also include all penalties for pre-payment or otherwise.

In my example I'm giving the total costs since my penalty happened to be zero.

Here's another way to narrow down between multiple offers/options:

Look at the cost per basis point of reduction.

In my example above, it was 125 bps for Rs. 18.6 k = Rs. 149/bp

and 175 bps for Rs 56 k = Rs. 320/bp

So at first glance its implying that the higher rate would save me more money.

This might be a more reliable guide since it takes into account the costs & fees also.

This division most of us can do on our mobiles also without messing with the PV function.

FYI:

PV [ rate, nPer, payment ]

PV = present value = max gross savings possible assuming no rate increase [best case]

rate = NEW interest rate [NOT annual but monthly compounded = 12th root of 1 + annual rate]

nPer = number of periods = remaining emi of loan tenure

payment = reduction in emi at the SAME tenure

NET savings = PV - total costs/fees/penalties

Is there any excel function to convert an annual rate into a monthly compounded?