Loan pricing more transparent now

When the Reserve Bank of India (RBI) changes the repo rate, the benefit (in case of a downward revision) is often not passed on to existing borrowers. It is only the new loans that are offered at the lower rates. However, this may change from April 1, next year.

In the latest Monetary Policy, the RBI has said that all new floating rate retail loans (housing, auto, etc) and floating rate loans to Micro and Small Enterprises extended by banks from April 1, 2019 would have to be benchmarked against external yardsticks. These could be repo rate or the 91-day or 182-day Treasury Bill or any other external benchmark. 

The move is expected to boost transparency, standardisation, and ease of understanding of loan products by borrowers. A bank will have to adopt a uniform external benchmark within a loan category, and cannot adopt multiple benchmarks within a loan category. But, borrowers should prepare for banks keeping a higher mark-up over benchmarks, upward movement in rates reflected quickly and changes related to their credit rating, experts tell DNA Money.

New system versus old

Currently, banks follow a system of internal benchmarks. All the earlier benchmarks including the Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base rate and Marginal Cost of Funds based Lending Rate (MCLR) followed this system. Due to internal benchmarking of the loan price, policy rate cuts often didn't reach the borrowers.

Once the benchmarking of floating rates to external benchmark starts it will depend on what benchmark banks will choose, what the spreads will be for each customer, etc, says Rajiv Anand, Executive Director, Retail Banking, Axis Bank. “The transmission of monetary policy rates will be faster because we will be using market-linked rates. Therefore, whether rates go up or down, in both cases transmission to the end customer will be very quick. Even with MCLR it happened. But in case of home loans were using six-month MCLR. So the loan was reset every six months. 

Under the new system we will have to see what frequency customers will be comfortable with,’’ he says. 

The existing loan benchmarks like MCLR (Marginal Cost of fund based Lending Rate), base rate, etc are internal benchmarks primarily based on the banks’ cost of funds. 

"This allows banks a lot of discretion while setting the benchmark rates and their spreads on them. As a result, their internal benchmarks did not always move in tandem with the broader interest rate movement, at least in the short term," says Ratan Chaudhary, Associate Director & Head of Home Loan, Paisabazaar.com.

The MCLR calculation is made on four factors - operating cost of the bank, tenor premium, marginal cost of funds, and negative cash carry on Cash Reserve Ratio (CRR). 

"The current system of MCLR, which will be applicable to floating rate loans till March 31, 2019, sees rates getting reset once a year, with a few lenders pricing on the 6-month period. Even as the MCLR is up for review every month, borrowers will service the debt at the prevailing MCLR on the loan reset date, irrespective of the changes made in MCLR in between. The spread is added to the MCLR to arrive at the actual lending rate for the customer to service at," says Rishi Mehra, chief executive officer, Wishfin.com.

The repo rate, which is currently at 6.50%, is decided on a bi-monthly basis. So, every two months the interest rate can change based on the change in the repo rate. The 91-day T-Bill Yield and 182-day T-Bill Yield are published on a daily basis. While the interest rate on loans on a 91-day T-Bill yield would be reset every three months, loans benchmarked to 182-day T-Bill yield would get a rate reset every six months

The proposed benchmarks are external benchmarks more or less following the broader interest rate movements. Any upward movement in the benchmarks will be reflected in the floating lending rates as well. The pricing of loans under the new external benchmark system is expected to be more in line with the broader interest rate regime. "If the RBI decides to reduce the interest reset period from once in a year to once in a quarter, as recommended by its own Internal Study Group, then the policy rate transmission for existing borrowers would be faster than the earlier regimes," says Chaudhary.

Spread issue

The RBI has directed that for all new floating rate loans the spread over the benchmark rate — to be decided wholly at banks’ discretion at the inception of the loan — should remain unchanged through the life of the loan. At present, the spread change depends on the loan agreement. At times, the spread can be reset by the bank at the end of a fixed period. This usually happens in case of special offers or schemes that come with a very low spread for a fixed tenor. In some cases, banks may also retain the right to reset the spread at its discretion. 

While this constant spread move is good, banks may adopt a cautious stance since they lose flexibility. "The spread in both repo rate and T-bill yields would be decided by lenders based on the credit record of borrowers. Since the spread in repo rate and T-bill yields is going to be fixed throughout the course of a loan, lenders may keep a higher mark-up portion over the benchmarks they choose to go with," says Mehra. 

In fact, the bank could have the card rate for home loan as a certain mark-up over the repo rate (or whatever benchmark), and depending on the borrower’s credit assessment, the mark-up would vary from borrower-to-borrower. This would be factored in to the loan contract. 

The spread over benchmark can change if the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract. Several factors can affect a borrower’s credit rating. The most important among these is timely repayments. "For example, if you had defaulted on payments at the time of taking your loan, your credit rating would be low and consequently, your loan would be more expensive," notes Navin Chandani, chief business development officer, BankBazaar.com. 

Same is the case if you had no credit history at all but after a couple of years, if you have paid your EMIs on time and generally improved your credit score and history significantly, then risk premium associated with your loan comes down significantly. In this situation, the bank may reassess the spread associated with your loan. "Other key factors that affect credit score include credit utilisation, credit enquiries initiated by banks when accessing your profile, and credit mix of secured and unsecured credit. If your credit utilisation is very high, or if you are regularly applying for fresh credit, your credit score can take a hit," points out Chandani.

HOW WILL YOUR LOAN RATE CHANGE

• Existing loan benchmarks like MCLR, base rate, etc are internal benchmarks primarily based on the banks’ cost of funds. This allows banks a lot of discretion while setting the benchmark rates and spreads
   
• The proposed benchmarks are external benchmarks following the broader interest rate movements. Any movement in the benchmarks will be reflected in the floating lending rates as well