How to manage rising loan interest rates

High and rising inflation is forcing interest rates for loans to rise. Here is a survival guide to adapt and survive the emerging harsh realities

Published: Mon 12 Dec 2022, 11:54 AM

By
Udayan Ray

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Like a rising tide lifts all boats, high and rising inflation across the globe is leaving no area of people’s finances untouched – whether it's home budgets, loans, or investments. To rein in the inflation monster, central banks across the world have raised interest rates; experts expect more of the same in the future. A September 2022 World Bank study titled “Is a Global Recession Imminent?” estimates average global interest rates to rise to 4 per cent in 2023 – up from 2 per cent in 2021.

Worryingly, experts do not expect the central bank rate hikes to be enough to bring down inflation. Across the world, it is expected to remain substantially higher than levels that existed before the outbreak of the global pandemic in 2020.

High inflation and rising interest rates are already causing economic downturn across the globe – a trend that is expected to gain pace in the future. This is likely to impact future pay hikes and job security, along with limiting investment income due to heightened volatility in financial markets. These conditions combined are creating new challenges for borrowers seeking new loans and those repaying existing ones.

Recent rate hikes have already pushed up interest rates on various loans, a trend also expected to continue in the future. Loan EMIs – be it for homes and cars, personal loans, or outstanding credit card balances – form a significant portion of many home budgets across the world.

How can one adapt to the emerging harsh realities? Here is a survival guide.

Survival guide during rising loan rates

The specific steps you need to take to adapt to rising loan rates will depend on whether you are planning to take a new loan, or repay existing ones.

Assess your situation. If it is your first loan, or you want a fresh loan after having fully repaid previous loans, first assess the impact of rising interest rates on EMI affordability, home budget, and interest pay out during the loan term and overall finances. Consider pruning the loan amount if you are planning to operate at an extreme margin of affordability.

Situation 1: Little impact

The overall impact of rate hikes will not be significant if you have no outstanding loans and the likely burden from loan EMIs are manageable – such as 10-20 per cent of take-home pay. For outstanding loans nearing the end of the term, typically with a higher principal repayment component in EMIs, a response may not be justified since effort and costs will outweigh savings in interest costs.

Situation 2: Significant or alarming impact

In this case, you will need to reduce the loan repayment burden. In extreme cases, for people with multiple loans struggling with repayment, the overall debt burden will need to be reduced with an action plan covering all loans.

Let us discuss the two scenarios in some more detail.

Loan management gameplan

New loans

If you have not ever taken a loan and are planning to do so, ensure the shortest loan tenure to keep overall interest payments under control. Also, ensure that loan EMIs never cross 40-45 per cent of take home pay.

If you are opting for a home loan, loan providers in your country of residence may have stipulations on loan amount as a percentage of pay. At the same time, ensure that they do not cross 35 per cent of take home pay.

Going up to the boundaries of prudent limits of loan repayment obligations still makes sense for a home loan for a self-occupied home and education loan. These two loans typically enhance your wealth and earning power, respectively.

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They also come with lower interest rates compared to substantially higher cost loans such as personal loans and credit card outstanding.

In the case of home and car loans, if rate hikes are stretching your finances, consider postponing the purchase till your pay catches up with the higher price tags. You could also consider downgrading your purchase. For instance, a lower car model and home in a different locality which fits your budget.

For new home loans, two important aspects need to be considered.

Fixed vs floating rating home loan

Examine whether you need to take a fixed or floating rate home loan. In the case of a fixed rate home loan, the interest rate will typically remain fixed for a certain period – say, two years. It is then highly likely to be linked to prevailing interest rates and remain so for the rest of the loan term. Thus, for a fixed rate home loan, only for a limited period, you will not be impacted by any home loan rate hikes.

On the other hand, with floating rate loans, rising interest rates mean home loan interest rates and EMIs will rise. It is important to note that interest rates for fixed rate home loans are typically higher than floating rate home loans. Thus, if you plan to eventually reduce your EMIs or loan tenure by partially prepaying your home loan early, a floating rate home loan is the one for you.

Seek home loan pre-approval

As you seek to buy a home using a home loan, consider a home loan pre-approval where the interest rate offered would be locked in for a certain period, often 2-3 months. Besides speeding up loan processing during the home buying process, it can also help you negotiate attractive discounts from sellers.

Existing loans

In a rising interest rate scenario, you will need to adopt measures based on the extent of increased burden of obligations for outstanding loans.

Seek home loan term extension

If the rise in home loan interest and EMI bites hard into your home budget, seek an extension of the home loan tenure from the loan providing institution. This will help reduce the EMI amount. It is unlikely that the extended term will be longer than your initial home loan term. The home loan provider will also ensure that, under all circumstances, the home loan is fully repaid before your retirement.

If a loan term extension is possible, do check out the additional interest payment you will now make during the extended loan term. With pay hikes over the years, and depending on home loan conditions, you could make part prepayments, especially if they are allowed with no prepayment penalties.

Consider home loan refinance

Another way of reducing the impact of high and rising home loan rates would be to explore taking your home loan to another home loan providing institution. Of course, such a move will be beneficial early in the home loan term.

Typically, during this period, the interest repayment portion in the home loan EMIs is higher than the principal repayment portion. At the same time, ensure that the savings in EMI from home loan balance transfer greatly outweighs any charges such as those for prepayment to the existing lender, processing, valuation, and registration, among others for the new institution.

Part prepay home loan

You can counter the impact of rising home loan interest rates by part-prepaying your loan. This will help you seek a lower home loan EMI. Of course, the home loan conditions need to allow for it and without any prepayment penalties. If home loan partial prepayment is allowed, you can use lump sum income from sources such as commissions, bonus, and stock options for this purpose.

Increase your EMI

While this may sound counter-intuitive, you can seek higher home loan EMIs from your home loan provider if EMIs form a small part of the take home pay. This will help you not only neutralise the impact of the home loan rate hikes, but also retire the loan early. The regular payments made towards EMIs can then be directed towards supplementing regular investments for major goals like retirement.

Managing significant impact

Reduce your debt burden

If with a hike in loan rates, rising inflation and economic downturn, you find the burden of loan repayment increasingly difficult to manage, plan an overhaul of your outstanding debt. Initially, this would help reduce the loan repayment burden.

Eventually, the roadmap will help you repay all outstanding loans and focus on enhancing savings for major future needs like retirement.

Watch out for danger signs of high debt

During times of rising loan rates and EMIs, it is important to watch out for danger signs of excess debt.

Here are some tell-tale signs of excessive debt:

Credit card limit regularly exhausted: You just pay the minimum amount due on credit cards with the outstanding amount constantly rising.
Withdrawing cash from credit cards: You do this to meet important and regular expenses.
Impact on meeting regular expenses: Loan repayments prevent you from meeting regular and important expenses.
Use of credit card instead of debit card: This is due to inadequate income.
Rejection of loan applications: This could be a result of payment defaults or decline in income.

Your debt management action plan

On detecting the signs and symptoms of unmanageably high debt, consider taking the following steps.

Pay off high cost debt

This means retiring high cost loans such as outstanding credit card amounts and personal loans. For paying off outstanding loans, consider liquidating some existing investments such as fixed deposits, equity, and debt funds, among others. While prepaying personal loans, find out about any prepayment or foreclosure charges. You will need to organise funds accordingly.

Replace high cost loans with lower cost ones

Selling off investments to repay costly loans will work only if the repayment amount is a manageable one, say, 10-15 per cent of your investments. For higher outstanding loan amounts, to reduce EMIs, replace high cost loans with lower cost ones such as secured loans or loans against assets.

This means repaying credit card outstanding amounts and personal loans with money from loans against fixed deposits, securities, and gold among different assets.

Consolidate your debt

If you have too many loans with a heavy repayment burden and tracking repayment obligations is cumbersome, seek a debt consolidation loan: a personal loan that helps you repay multiple and costly loans and helps you focus on repaying a single loan. Debt consolidation loans are appropriate for consolidating multiple loans such as those from multiple credit cards.

Debt consolidation loans need to be part of a long term plan that will not only eliminate the loan repayment burden eventually, but also rectify financial behaviour that led to this situation. For such loans, you typically need to have a minimum credit score stipulated by financial organisations. Furthermore, the interest rate, along with the fees and charges need to be substantially lower than the regular repayment amount of existing loans.

For outstanding debt on multiple credit cards, you could also explore balance transfer to another bank. This involves the transfer of credit card debt which will typically be paid through EMIs. The EMI conversion option is likely to be available in your existing bank.

Balance transfer will work till a certain loan size and will be available for a shorter period than a debt consolidation loan. Thus, you need to compare various options on various parameters before opting for one.

Despite the various difficulties from high and rising interest rates for loans, the emerging circumstances drive home an invaluable lesson. You may grab a part of your future income to use for your present needs by taking out a loan, but you will still have to settle the bill one day. Make sure that it is never too high.

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