The Reserve Bank of India has issued a circular dated September 4, 2019, making it mandatory for all new floating rate loans from October 1, 2019, to be linked to an external benchmark. This applies to all floating rate retail and MSME loans.
What does this mean for you if you are an existing borrower or plan to take a new loan?
Before we jump on the new announcements, let’s quickly look at the difference between fixed and floating-rate loans. Under a fixed-rate loan, your loan interest rate remains constant for the entire duration of the loan. Under a floating rate loan, you are offered loan at a Benchmark + Spread. As the benchmark (Base Rate, MCLR, RLLR) changes, your loan interest rate also changes.
Back to the RBI circular. Some of the prominent announcements (and what that means) are as follows:
All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from October 01, 2019 shall be benchmarked to an external benchmark. The banks can choose one of the following as the external benchmark for a loan product.
- RBI Repo Rate
- Government of India 3-Months Treasury Bill yield or 6-months Treasury Bill yield published by the Financial Benchmarks India Private Ltd (FBIL)
- Any other benchmark market interest rate published by the FBIL
What this means?
MCLR will soon be history, at least for the new retail and MSME borrowers.
If your bank is offering you a fixed-rate loan, the external benchmark will not apply.
This is not the first time the banks would launch retail loan products linked to an external benchmark. SBI launched a Repo-rate linked home loan (RLLR) in July 2019. By the way, the banks don’t necessarily have to use Repo-rate as the benchmark. They can use any of the aforementioned benchmarks for their loans. In fact, Citibank launched a home loan product linked to 3-month Treasury Bill rate a couple of years back.
The linkage to external benchmarks shall only apply to banks. As of now, Housing Finance Companies (HDFC, LIC Housing Finance etc) are excluded from this rule and don’t have to link their loans to external benchmarks.
What about the existing borrowers on Base Rate or MCLR?
Existing loans linked to Base Rate/MCLR/BPLR can be continued without any change until maturity. The bank cannot force you to switch to the external benchmark.
If you have a floating rate loan where there is no prepayment penalty, you can request your bank to link your loan interest rate to an external benchmark. Note “Floating Rate” and “No prepayment penalty”. Most home loans will fall under this category.
As for the charges for such a switch, RBI says that such a switch shall be allowed without any charges/fees, except reasonable administrative/ legal costs. As I understand, there shouldn’t be any significant charges for switching. We will see how the banks will interpret it or if there are any loopholes in such a statement.
What will be the rate of interest after the switch? Should you switch?
RBI circular further mentions (for switch cases) that The final rate charged to this category of borrowers, post switchover to external benchmark, shall be same as the rate charged for a new loan of the same category, type, tenor and amount, at the time of origination of the loan.
As I understand, if you are switching, you would get a rate that a new borrower would get.
When borrowers switched from Base Rate to MCLR, there were given two options:
- Switch to MCLR while keeping the rate constant without paying any fee. Essentially, the bank would tinker with the spread and keep you on the same rate of interest. Any benefit will accrue due to changes in MCLR in the future. So, if your loan interest rate under base rate was 9% and MCLR was 8.5%, your spread would be 0.5%. If your loan interest rate was 9.25%, the spread for you will be 0.75%.
- Switch to a lower rate (that a new borrower with your credit profile would get) by paying a fee. This made calculations quite complicated for many borrowers. They had to do a complex cost-benefit analysis.
As I understand, now you will have an option to switch to a lower rate (that a new borrower with your credit profile would get) without paying any fee. Essentially, the bank will not be able to tinker with the spread just to keep the interest rate constant. Or so I think. The banks typically find out a way. A good move by RBI. You can simply compare the existing and the new interest rates and decide.
Other Points to Note
The interest rate under the loans linked to an external benchmark will be reset at least once in 3 months. This means your loan interest rate will change/reset every 3 months or less. This is again to effect quick transmission. Many MCLR loans had reset period of up to 1 year. By the way, SBI Repo rate linked home loan has a reset period of 1 month (interest rate can change every month).
A bank must adopt a uniform external benchmark within a loan category. In other words, the adoption of multiple benchmarks by the same bank is not allowed within a loan category. For example, a bank can’t have a few home loans linked to repo rates while the others are linked to 6-month treasury yields. A good move again.
About the spread on these loans, the banks are free to choose the spread over the external benchmark. The spread can change if your credit profile undergoes a significant change. There is provision to change spread due to increase in operating costs once in 3 years.
The banks are free to offer such external benchmark linked loans to other types of borrowers as well. If the banks wish, they can extend this rule to corporate borrowers too. Not that you should care.
What to expect? What should you do?
Now that the deadline is only a few months away, there will be a rush to launch home loan products linked to external benchmarks.
From the borrower perspective, this move brings in more transparency. When things are not transparent, the more resourceful party (the bank) is likely to benefit at your expense (the weaker party). Therefore, it is clearly a good move from a borrower’s perspective. The externally benchmarked loans can be quite volatile since both rate cuts and hikes will be passed on quickly. However, given how the banks work, you are better off in a more transparent regime.
From the banks’ perspective, I am not very sure. RBI, in December 2018, had mandated that all new loans from April 1, 2019, had to be linked to external benchmarks. The move was put on the back burner due to banks’ resistance and now it has been brought back. The banks have issues with external benchmarks and some of them are justified too. The liabilities (deposit interest rates) are not linked to external benchmarks. Moreover, the deposit rates compete with other products such as small savings schemes (that do not really move with market interest rates). We will have to see how this affects the banks’ interest margin and performance. For now, linkage to external benchmarks is only for retail and MSME loans.
Do note only banks are required to link new loans from October 1, 2019, to external benchmarks such as Repo rate. Housing Finance Companies (HFCs) such as HDFC are not required to link to external benchmarks. Therefore, if you are planning to take a new loan, explore your options with the banks first. You will not get such transparency in the interest rate from the Housing Finance Companies. If you have an existing loan from an HFC, consider shifting your loan to a bank. Easier said than done but clearly worth a shot.