How to make the most of falling interest rates

Investors could look at debt mutual funds and company deposits that give higher returns; home loan borrowers could transfer loans

The jury is out on whether the Reserve Bank of India will cut its key interest rate this Tuesday.

There are indications we are headed for a lower rate regime, courtesy banks, which might finally blink after holding on to rates despite two out-of-policy cuts by the central bank this calendar year.

Most bankers say they will look at reducing deposit rates from April.

Banks are no longer under pressure to immediately protect their margins.

So, if a rate cut is round the corner, what impact will it have on your investments and loans?

A look at some of the things to keep in mind:

Investments

For those looking to invest in bank fixed deposits or renew FDs, do it right away.

“If you have surplus funds, rush and put them in bank FDs before rates fall,” says financial planner Gaurav Mashruwalla. Currently, most banks offer eight-nine per cent on deposits of one-three years.

An option is to look at long-term debt mutual funds, including income or gilt funds, which will provide capital gains when rates fall.

This is because bond prices are inversely proportionate to interest rates.

According to Value Research, the returns from medium and long-term gilt funds are 17.44 per cent, while returns from income funds are 13.45 per cent.

“For the short- to medium-term horizon, investment in bonds and debt funds would be a more suitable option compared to traditional bank FDs and recurring deposits.

“For long-term investments, one should have higher exposure to equity markets,” says Nitin Vyakaranam, chief executive of Arthayantra.com.

If you have invested in short-term FDs (one-two years), shift to short-term debt funds.

If investing in short-term debt funds and FDs with a maturity period of up to five years, shift to income funds and fixed maturity plans.

Also, increase your exposure to equity markets by 5-10 per cent.

But, remember, not all debt funds are useful in a falling interest rate regime. For instance, in a low-rate regime, you might be better off investing in a short-term bank FD than a liquid fund or cash fund.

“A short-term bank FD will give guaranteed returns, but a liquid fund that invests in short-term papers does not offer guaranteed returns,” says Mashruwalla.

The rates on liquid debt funds and short-term bank FDs of up to nine months are comparable; both offer eight-nine per cent.

Loans

Borrowers benefit from an interest rate fall, especially in case of a floating rate loan. Typically, banks give only home loans on a floating-rate basis.

Other loans, such as automobile loans and personal loans, are fixed-rate ones and a fall in the interest might not have any impact.

In case of an interest rate cut, it is common practice by banks to reduce the tenure and keep the equated monthly instalments constant, says Gaurav Gupta of MyLoanCare.in.

When a loan is linked to the base rate, the rate automatically falls in case of a rate cut. But borrowers should check whether the bank is changing the spread over the base rate, too, to charge higher interest.

If that is so, borrowers might not benefit from lower rates.

In the case of home loans from housing finance companies, for which the rate is linked to prime lending rates, a cut in interest rate isn’t passed on to existing borrowers, as the spread is ‘minus PLR’.

In such cases, borrowers can move to a lower interest rate band after paying a fee to the HFC (typically 0.25 per cent of the loan due), or shift to another lender.

If one transfers the loan, one has to incur additional charges such as processing fees, legal fees and stamp duty, as well as registration charges.  

Some banks ask borrowers to register the new loan agreement while transferring the loan. While processing fees aren’t very high, the case might be different for stamp duty and registration charges.

“If the difference between the rate you are paying and the rate you are offered is less than 50-75 bps, it doesn’t make sense to shift,” says Gupta.

Impact on retirees, senior citizens

The impact of falling interest rates is felt most by retired people and senior citizens, dependent solely on fixed-income instruments.

As low interest rates put pressure on more popular instruments such as bank fixed deposits, senior citizens should not miss the opportunity to invest in deposits with higher interest rates, which many banks offer.

Also, one can look at investing a part of the portfolio, say 10-15 per cent, in high-rated corporate FDs, says Abhishake Mathur, head (financial planning services), ICICI Securities.

Ideally, they should also look at including some equity in their portfolios.

“Usually, a fixed income deposit gives only one-two per cent higher returns than inflation.

“And, when you account for taxes, the effective returns from debt instruments are very often just enough to match inflation rates.

“Retired people or those nearing retirement typically do not view equities favourably because of their volatile nature.

“That should change,” Mathur says.

A retirement corpus should be divided into two parts.

One which will give regular returns and another that will give growth to the portfolio.

If you have a corpus of, say, Rs 1 crore (Rs 10 million) at the time of retirement and if you are not dependent on the entire portfolio for returns, it is advisable to keep 15-20 per cent of the portfolio in equities for growth.

Choosing large-cap mutual funds can help keep volatility as low as possible.

“While investing for the long term, don’t be totally risk-averse, especially if you are 55-60. A retirement corpus has a long-term horizon of 20-30 years and, therefore, it should have a growth component,” adds Mathur.

WHERE TO INVEST:

Single person between 22 and 25 years:

Goals: Short-term goals such as higher education and wedding

Recommend action: Switch to a mix of debt and equity, with debt exposure of 55-60 per cent because of the short-term nature of the goal. Invest the rest in equities

Married person (25-45 years), with children:

Goals: These investors are medium- to high-risk. Goals include long-term ones such as children’s education and retirement

Recommend action: Have a higher exposure towards equity markets.

A rate cut is a positive sign for equity markets, as it indicates inflation is under control. These investors could have equity exposure of 60-65 per cent; the rest could be in debt

Senior professional (45-55 years)

Goals: These investors come under the low- to medium-risk category.

Typically, goals include planning for retirement

Recommend action: These investors tend to invest more in fixed-income securities such as bank fixed deposits and recurring deposits.

Instead, they could invest in income funds and bonds.

The recommended asset mix is 50:50 towards equity and debt