Easy on the pocket

Cheaper loans is good news for borrowers but they must look out for spread and product structure

Lending rates on your home, vehicle and personal loans could get cheaper. Last week, the RBI mandated banks to link new floating rate personal and retail loans to an external benchmark from October 1, 2019. The external benchmark can be the RBI’s repo rate, the 3-month treasury bill yield or the 6-month treasury bill yield. Up until now, loans were linked to the bank-specific benchmark — MCLR (marginal cost of funds-based lending rate).

There are several nuances in the new structure that borrowers need to be wary of.

Better transmission

Floating rate loans, whether for buying a new house or a vehicle, are pegged against a particular benchmark. Until now, each bank decided its benchmark based on its cost of deposits or borrowings. Given that each bank’s cost is different, MCLR also varied across banks.

Ideally, when the RBI cuts or hikes the repo rate, banks’ MCLR should also move in tandem. But given that banks only source a small portion (1%) of their deposits at RBI’s repo rate, banks’ cost of funds reduce or increase by a smaller amount (than repo rate movement), limiting the changes in MCLR.

Under the new repo-rate-linked system, RBI’s rate actions will get transmitted almost immediately. Let us take the case of SBI. It introduced the repo-linked home loan in July. Lending rates change every time the RBI tweaks its repo rate.

The repo-linked lending rate or RLLR changes from the first of the following month in which the RBI changes its repo rate. With the RBI’s 35 bps repo rate cut in August, SBI’s RLLR has reduced to 7.65% since September 1 (from the 8% earlier).

Hence, for home loans up to ₹75 lakh, the effective interest rate for borrowers with a good credit score works out to 8.05% (including mark-up of 40 bps over RLLR) currently.

In comparison, the rate on SBI’s MCLR-linked home loan now is 8.65%.

Takeaway 1: Loans under the new external benchmark structure will get cheaper if the RBI continues to cut rates. On the flip side, be prepared for a higher payout when the RBI starts hiking rates.

Base and spread

Borrowers should be wary of two things.

One, even if banks link lending rates to the same external benchmark, the resultant base rate would vary across banks initially due to different spreads by each bank.

For instance, consider SBI and IDBI. Both banks have already linked their home loans to repo rate. But their RLLR varies. For SBI, while the RLLR is 7.65% currently, for IDBI Bank it is 8.3%.

While any action by the RBI in future will see lending rates move higher or lower by the same quantum in both banks, since the initial base rate is different, the effective rate for borrowers would vary.

Two, banks arrive at the effective rate by assigning a mark-up over the benchmark. This is based on the risk-profile of the borrower and could also differ across banks. In case of SBI, for instance, while the spread is 40 bps, in the case of IDBI Bank the spread charged over and above its RLLR is zero in case of borrowers with a high credit score of 750 and above.

Though the effective lending rate for SBI still works out cheaper, borrowers need to take note of the mark-up at all times.

Takeaway 2: Borrowers must take note of the underlying benchmark and spread while finalising the loan, and then compare across banks.

Reset rules

Under the external benchmark structure, the RBI has mandated that loans are reset at least once in three months — provided, of course, that there are changes in the underlying repo or t-bill yield. This means that your lending rate will be revised much faster. In case of SBI’s home loan product, changes to lending rates happen immediately (within a month of change in RBI’s repo rate).

Aside from quicker transmission, this also implies other changes in your monthly payouts.

Under a regular home loan product, your equated monthly instalment (EMI) on home loan is fairly stable. Even when the lending rate is reset based on the latest MCLR, banks usually change the tenure (lower the tenure in case of a fall in rates) of your loan rather than EMI — unless you specify otherwise. This, in effect, keeps your EMI steady.

Under SBI’s RLLR, however, a minimum 3% of the principal loan amount is repaid every year. Interest charged on the loan is serviced monthly, based on the lending rate effective at that point in time. Hence, your EMI changes (in the following month) every time there is a change in RBI’s repo rate.

For now, it is unclear how other banks will structure their products under external benchmarks. For instance, they could offer a steady EMI.

Takeaway 3: Look at individual products and understand their structure before deciding if predictability in EMIs is important to you.

Existing borrowers

The RBI has also allowed existing borrowers under MCLR to move to the external benchmarked-loans, without levy of any charge or fee. Given that loans under the new structure will most likely be cheaper than under MCLR, in a particular bank, borrowers should consider making the switch.

However, do take note of any hidden charges (RBI has allowed some administrative/ legal costs) before making the move. Also ensure that you are offered the same lending rate as a new borrower under the external benchmark regime.

It may be prudent to also weigh in the benefits. If you are nearing the end of your existing loan, it may not make sense to make the switch. If you do not care much for volatility in your EMIs, then consider the move only if the interest savings are substantial.

Also, as of now, it appears that the no-charge/fee mandate applies only to a switch within the same bank. If you are making a move from one bank to another, there could be additional charges.

Takeaway 4: Switch to external benchmark loans only if the remaining tenure of your loan is long and interest savings are substantial.

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