Banks Told To Link Home Loans With External Benchmarks From Oct 1
Banks will have to link their housing loans with an external benchmark from October 1, 2019, with the Reserve Bank of India (RBI) directing them to do so in order to ensuring faster transmission of policy rate cuts to borrowers.
In a circular issued on September 4, 2019, the RBI said it had been observed that due to various reasons, the transmission of policy rate changes to the lending rate of banks under the current marginal cost of funds based lending rate (MCLR) framework had not been satisfactory.
The external benchmarks, to which the banks will be required to link their lending rates, could be the repo rate, the three-month or six-month treasury bill yield or any other benchmark published by the Financial Benchmarks India Private Ltd (FBIL). The banks have also been asked to reset the interest rate under external benchmark at least once in three months.
The circular further said while the banks are free to decide the spread over the external benchmark, the credit risk premium "may undergo change only" when borrower's credit assessment undergoes a substantial change. Other components of spread including operating cost could be altered once in three years, the RBI said.
Banks that have already linked home loans with repo rate
It begs mention here that after the country's largest public lender, State Bank of India (SBI) unveiled its plan to link its home loan and deposit rates to the repo rate in May, 2019, several state-run financial institutions decided to join the bandwagon. Among the banks that have announced linking of their home loan and deposit rate with the repo rate, after the Reserve Bank of India (RBI) reduced its key lending rate to a record low of 5.40 per cent in August 2019, are Bank of Maharashtra, Syndicate Bank, Bank of India, Bank of Baroda, Union Bank, Indian Bank, United Bank of India and Allahabad Bank.
Existing borrowers in these banks, who are servicing their home loans on the marginal cost of funds-based lending rates (MCLR), will have the option to switch to the new repo-linked lending rate (RLLR). New borrowers will also have the option to pick one between the two.
The question that arises is, how are the two different and why should you choose one over the other?
The MCLR-versus-RLLR debate
In order to ensure better policy transmission from banks to consumers, the RBI, in April 2016, introduced the MCLR regime, which replaced the prior base rate regime. However, the switch made little impact. Banks have reduced their interest rates on fresh rupee loans only by 29 basis points (bps) this year so far, as against the 75-bps repo rate cut announced by the RBI till July, 2019.
Considering that the MCLR is an internal lending benchmark and banks 're-set' the loan rate only at an interval specified in the loan agreement, rate cuts implemented by the banking regulator, i.e. RBI, were not passed on to the customers by the banks as swiftly as they were expected to. In the case of home loans, banks typically kept a one-year re-set clause. This meant that even if the RBI lowered its repo rates multiple times in a year, you would see your EMI going down only after the bank re-adjusted it as mentioned in the agreement.
Banks showed their inability to lower rates to expected levels, because only one per cent of their total borrowing comes from the RBI while the remaining comes through deposits. This is also a reason why banks lower deposit rates before they lower home loan interest rates.
"In the case of MCLR-based loans, banks have to factor in their cost of deposit, operating cost, etc., apart from the repo rates while calculating rates. Hence, MCLR-based loans are always likely to have slower transmission of policy rate changes," says Paisabazaar.com CEO and co-founder Naveen Kukreja.
Disappointed by the MCLR regime's limited success, the RBI in 2018 also directed banks to switch to an external lending benchmark so that the borrowers are better placed to reap the benefits of changes in monetary policy.
Should you make the switch to repo rate linked home loans?
To find a proper answer to that question, we have to understand several things first. As is true under the MCLR regime, the discretion to charge additional interest on top of the repo rate, lies with the banks. The repo rate currently stands at 5.4 per cent, for instance but Bank of Baroda is going to charge 8.35 per cent interest on repo rate-linked home loans. The difference between the two rates is of 295 bps. However, when compared to its MCLR of 8.45 per cent, the repo rate-based home loan is 10 bps cheaper.
The RBI announces its monetary policy once in two months, in which it takes a decision on lowering/increasing/maintaining status quo on the repo rate - the rate at which it lends money to scheduled banks. Interest on a home loan that would be linked with the repo rate would change as soon as the RBI makes any change. This means the 'reset' clause that banks have under the MCLR regime, would be out of the picture.
"With repo-rate linked home loans, borrowers can expect a much faster transmission on to their loan rates. Also, such loans will be more transparent as far as the rate-setting mechanism is concerned and should add more certainty to the borrowers in anticipating their loan interest rates," points out Kukreja.
However, this cuts both ways. If the RBI decides to increase rates in quick succession due to market conditions, borrowers would also find their EMIs rising with immediate effect. "Borrowers need to keep in mind that repo-rate linked loans can work against them during the rising interest rate regime. These loans will witness faster increase in their rates, in the case of repo rate increases by the RBI," Kukreja cautions.
However, at the same time the deposit rates would increase, too, somewhat lessening the impact of the loss. Similarly, when the RBI reduces repo rate, home loans could become cheaper but deposit rates would also go down. Since May 1, 2019, for instance, SBI savings bank accounts with balances of over Rs 1 lakh are earning interest at the repo rate, minus 2.75 per cent. Depositors who have that kind of money in their account, are currently earning only 2.65 per cent interest. So in either scenario, a customer, who has invested in these two saving instruments, doesn’t make any major gains.
Want to know what spread is? Read this.