Impact of Increasing Interest Rate on EMI
Past few months has seen annoying actions in the interest rate scenario. With Reserve Bank of India trying to fight inflation by increasing rates on one front, on another front every bank and financial institution has been passing burden of these interest hikes almost directly to the borrower.
Therefore, a higher interest rate would mean that customers have to pay more out of their pocket towards servicing their loan. This extra burden will ultimately tighten the cash flow of customers. This could in turn prompt them to default. On the other hand, will it actually? The answer is no. Interest rate hikes resulting in increase in defaults is a far-fetched idea. Here’s why:
Lenders follow two different strategies to implement interest rates hikes:
- Raise the customer’s monthly EMI to reflect the new rates
- Extend the tenure of the loan by a few months/years
The chances of a customer defaulting occur when he/she has to shell out more per month due to a rate hike. In scenario ‘2’, this is not true as there is no chance in the monthly EMI, hence ensuring that there is no net effect on the borrower’s monthly finances. This will eventually effect 10-15 years later when the tenure for loan is about to end.
In practice, most lender implement interest rate hikes by using the 2nd method. This preference is for three reasons:
- This is more hassle free in terms of administrative changes and related paperwork. All that the ender has to do is send a letter stating an increase in the number of EMIs and things continue as they are
- An increased tenure will also mean that the lender gets the benefit of higher net interest income as the customer has to pay interest for a longer period
- Since customers do not feel the pinch immediately or even in the medium term, there will not be any major complaints or anxieties.
So, if above points are considered from the point of view of Customers, it can be concluded that when the tenure is prolonged to reflect an increased rate of interest, the chances of customers defaulting is almost nil.
What if the Customer defaults?
If the borrower defaults on a loan consistently for 3 to 6 months, the lender will report this to the Credit Information Bureau Limited (CIBIL). If his credit score is poor in CIBIL, there is little change for a borrower to borrow again from any reputable banks and NBFCs. The score is updated regularly on the basis of the defaults and late payments on loans, higher component of unsecured loans (credit cards, personal loans), and higher credit limit utilization on cards.
The score varies from 300 to 900. The higher the score the better the possibility to get a loan. A bad credit history can ruin the borrower’s credibility and takes a long to get that back on track.
Important Point: Although it is always better to go for a higher EMI as against a longer tenure. But in case if the cash flow in/out is very tight then it is better to go for a longer tenure rather than default on the repayments and credit report.