The Reserve Bank of India (RBI) has issued a circular making it mandatory for banks to link all new floating rate personal or retail loans and floating rate loans to MSMEs to an external benchmark effective October 1, 2019. The central bank has allowed banks the freedom to choose one of the several benchmarks indicated in the circular. The banks are also free to choose their spread over the benchmark rate, subject to the condition that the credit risk premium may undergo change only when borrower’s credit assessment undergoes a substantial change. Does this mean interest rates on your home loan, car loan etc will get automatically cheaper from October? There is many a slip between the cup and the lip. So, you to have read the details.

‘New’ floating rate loans only

The RBI direction applies to new loans taken by individual borrowers from banks. So, these are ‘new’ loans. Also, these are floating rate loans, which means fixed rate products like personal loans will not get benefit if they are ‘new’.

Since the RBI direction covers banks only at this point, this also means if your loans are from housing financing companies like HDFC, LIC Housing Finance, you will not get benefitted.

Benchmark brouhaha

Do remember that the RBI has allowed banks to link the loan to an external benchmark, and banks are free to choose which benchmark they select. Which are these benchmarks, or yardsticks, that will decide loan interest rate pricing? We will tell you. The external benchmarks the RBI proposed are policy repo rate, the Government of India’s three-month and six-month treasury bill yields published by Financial Benchmarks India Private Limited (FBIL), or any other benchmark market interest rate published by FBIL.

Banks are free to offer such external benchmark-linked loans, but the banks must adopt a uniform external benchmark within a loan category. This means if a bank adopts policy repo rate as its benchmark for new floating rate home loans, it will have to offer the same benchmark for all new floating rate loans. This is to ensure transparency, standardisation, and ease of understanding of loan products by borrowers.

The interest rate under the external benchmark shall be reset at least once in three months.

Timing on lower rate benefit

A very important thing that you should remember is that merely shifting to external benchmark regime may not immediately get you a huge cut on interest rate from October 1. This is because the external rate falls only when future interest rates drop.

However, if you are at this moment (pre-October 1) paying more interest rate, then shifting to new external benchmark regime will definitely cut rates for you and you may get an instant benefit. Pay attention to the interest rate proposed to be charged by a bank from October 1 on such loans. Find out the difference between new October 1 rates and what you currently pay on such loan(s).

Better than old?

From October 1, 2019, any new floating-rate loan taken by you from a bank will be linked to the above mentioned external benchmarks. The benchmark choice will depend upon the bank.

The interest rate you will pay will be the external benchmark plus a fixed spread. This means if the external benchmark is 6% and spread is 2%, you will pay 6 + 2 = 8% interest.

If the external benchmark moves lower, you will pay lesser interest. If the external benchmark moves higher, you will pay higher interest. Do note that spread is fixed for the tenure of the loan i.e. 10, 20, 30 years whatever loan tenure you have chosen. Generally, the spread will not change.

However, there is some freedom given by the RBI to banks to even change the spread under specific conditions. For instance, if the borrower’s credit assessment undergoes a substantial change, the bank can change the spread. This should work in both cases i.e. borrower’s credit assessment improves or deteriorates.

Also, the RBI has allowed banks the freedom that other components of spread including operating cost could be altered once in three years.

Should you shift existing loan to new bank?

All is not lost for existing floating-rate loan customers of different banks. You may have the option from October 1 to move to the new regime of external benchmarks. But, this will likely come at a cost.

For instance, your bank may charge you a hefty one-time processing fee to shift. Banks lose interest income in the external benchmark model, and hence they may try to put this processing fee, etc. to recover some money when you shift.

Do note that once you shift to the external benchmark regime, it is unlikely that you will be allowed to shift back. So, weigh the pros and cons before shifting. There are benefits in going in for a more transparent model of interest rate pricing, but consider the costs too.

RupeeIQ take

Floating rate loans are best if you expect interest rates to fall further. If rates are expected to move up, then fixed rates help you lock a lower rate. The external benchmark is for faster interest rate transmission and this will work during both rise and fall of interest rates.

The existing MCLR (Marginal Cost of fund based Lending Rate) based interest system has been very inefficient in terms of passing lower interest rates to borrowers. So, let us hope the external benchmark regime will work more in favour of bank borrowers.

We must tell you that a borrower with a poor credit score will be charged a higher spread (premium over the benchmark). Unless your credit score improves substantially, that spread will always remain high. This could mean that despite a lower external benchmark rate (compared to MCLR), a poor credit score may finally end up keeping your effective interest rate higher in the new system.

Author
Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. He can be contacted on kumarsroy@rupeeiq.com