Converting savings from lower EMI into deposits not worth it

State Bank of India officials are persuading their home loan borrowers to convert their savings on lower EMI (home loan) into deposits with the bank.

The country’s largest lender had recently cut its rates on home loans, thus resulting in a lower EMI. It is this savings that the officials are talking about.

For a 20-year Rs 20 lakh loan, the EMI will fall to Rs 966 per Rs 1 lakh from Rs 982, a report in Business Line said.

Explaining the rationale behind the advice, bank officials quoted in the report, said if a borrower park this Rs 320 per month savings in a recurring deposit (RD), which offers an 8.50 percent return, he would save Rs 200,640 (assuming the RD for the initial 10 years is later extended for another 10 years).

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An RD requires you to invest a minimum fixed amount every month for at least six months. The maximum tenure possible is 10 years but can be extended thereafter.

At the outset, bankers’ advice sounds good. But, as always, the devil is in the detail.

What our number says: Let’s assume, you took a Rs 20 lakh loan for 20 years at a rate of interest of 10.75 percent. Your EMI was Rs 20,305. The total cost of the loan will be Rs 48,73,200, while the total interest amount you pay will be Rs 28,72,848.

Let us assume that you paid the loan for a year and now your new outstanding amount is Rs 19,69,885.

The bank reduces interest rate by 25 basis points to 10.50 percent. New EMI will be Rs 19,978, with your savings at Rs 327.

Option 1: You choose to pay the lower EMI. The total cost of the loan for the remaining tenure would be Rs 45,54,984.

Option 2: You choose to continue paying the earlier EMI, i.e. Rs 20,305. Your tenure falls to around 18 years from 19. Besides, the total cost of the loan for the remaining tenure will be Rs 44,06,185.

Option 3: You find the banker’s advice attractive and open an RD to invest Rs 327 every month for 19 years at 8.50 percent. You make Rs 184,625. Tax-adjusted returns for the highest tax bracket will be around Rs 135,690. And total cost of your loan for the remaining tenure would be Rs 45,54,984.

Comparisons: Consider Option 2. Add the cost of loan for 1 year (which you have already paid) Rs 243,660 to the cost of loan for remaining 19 years, Rs 44,06,185. This will give the total cost of your loan, which is Rs 46,49,845.

Now consider Option 3. Add the cost of loan for 1 year (which you have already paid) Rs 243,660 to the cost of loan for the remaining 19 years Rs 45,54,984. This will give you the total cost of your loan at Rs 47,98,644. Now, subtract the earnings from the RD, i.e. Rs 1,35,690. On a net basis, the total cost of your loan will be Rs 46,62,954.

The inference is, by choosing to keep the higher EMI amount, you save Rs 13,109 and the repayment will be done one year earlier, which is definitely better than lowering your EMI and investing the savings from it in an RD. The sooner you repay your loan, the better.

Spotted the devil? The moral is, do the math on your own before blindly following bankers’ advice.