Transparency in interest rates on Home Loans?

One of the major grouses of millions of existing home loan borrowers is that while they are forced to pay higher rate of interest, Banks and Home Finance companies (HFCs) offer lower interest rates to attract new borrowers. They are disillusioned to note that after establishing their impeccable track record of regular repayments and being loyal to the lender, when morally they should be rewarded with lesser interest rate than new borrowers, it is the other way round. New borrowers are getting enticed with home loans at lower interest rates and existing borrower’s pleas are not heard either by lenders or by regulatory authorities.

Fixed interest rates to variable interest rate schemes:
Until the dawn of twenty first century, the portfolio of home loans in the overall debt portfolio was negligible and as such the fixed rate of interest, which was in practice, was a feasible option. With setting up of National Housing Bank (NHB) in 1988, followed by establishing specialized housing finance companies (HFCs) and thrust given by foreign banks and new generation private sector banks in increasing home loan lending resulted in quantum jump in outstanding debt of long term loans. Since the risk of interest rate movement has to be borne by lender in case of fixed rate loans, it became necessary for banks/HFCs to shift to variable interest rate schemes.

Since risk of interest rate movement was transferred onto the borrowers, Banks and HFCs could reduce interest rates by 2-3% as compared to fixed rate loans. Very soon variable rate home loans became popular and by 2015, almost 95% outstanding loans were under variable rates and outstanding home loan portfolio crossed Rs. 6 lakh Crores.

Discriminatory methods in charging interest:
In a bid to improve their bottom-line, Banks and HFCs started using discriminatory methods to calculate interest rates for variable rate home loans. The interest rates were increased instantly when interest rates went up in the economy and seldom Interest rates were reduced when interest rates came down. To attract new customers, banks and HFCs offered lesser interest rates and compelled existing borrowers to pay higher interest.

The regulatory authorities like RBI (Reserve Bank of India) and NHB (National Housing Bank) started getting innumerable complaints from borrowers on injustice meted out to them by Banks and HFCs and suggested regulators to advice lenders to make transparent methods of fixing interest rates. The regulators had to intervene and issue guidelines to Banks and HFCs on proper methods of calculating interest rates. First it was PLR (Prime Lending Rate) method during 2001-2010 and later Base Rate method from 2010 to 2016 and furhter MCLR Rate method from 2016 till now. Although there were some improvements in transparency in fixing interest rates, the objective of
safeguarding borrower’s rights and total transparency could not be achieved.

MCLR Regime:
In the Base Rate regime, the lending rate was calculated on cost for the funds (average interest rate given for deposits), operating expenses, minimum rate of return (profit), and cost for the CRR (Cash Reserve Ratio of RBI). Banks were having leeway of delaying or not passing on reduced cost of funds to borrowers due to non-transparent method of calculating Base Rate.

After considering concerns of all stake holders Reserve Bank of India (RBI) has recently issued guidelines on fixing interest rates for various loans on a new method called MCLR (Marginal Cost of Funds based Lending Rate), which has come to effect from April 2016.

In the MCLR method, while calculating the lending rate, the main criteria shall be to consider the changed cost of funds on monthly basis, which is termed as marginal cost conditions, apart from considering negative carry on account of CRR, operating cost and tenor of loans. Most relevant factor of the MCLR system is that it facilitates monetary transmission, as it is obligatory for banks to consider the Repo rate while calculating their MCLR.

According to the guidelines, the marginal cost should be calculated on interest rate given for various types of deposits, namely savings, current, term deposit, foreign currency deposit etc., borrowings, like short term interest rate or the Repo rate (the rate at which the RBI lends money to commercial banks in the event of any shortfall of funds), long term rupee borrowing rate and return on net-worth (as per capital adequacy norms).

To have transparency, RBI has stipulated that the cost of borrowings shall have a
weightage of 92% of cost of marginal funds and return on net-worth will have the
weightage of 8% only. That means, the MCLR will be determined largely by the
marginal cost for funds and by the Repo rate. Since any change in Repo rate will effect changes in marginal cost, compelling the automatic change in the MCLR.

The actual lending rates will be fixed by adding the margins to the MCLR, depending on the risk factors, like secured, unsecured, short term, long term, borrower’s credit worthiness etc.

MCLR method lead to slightly better transparency in fixing interest rates on loans and effecting change in interest rate as and when interest rate changes happen in the economy. But still remained far below to the expected levels of transparency as MCLR rate is an internal benchmark of the lender.

Linking interest to External Benchmark rate:
The long pending demand of linking interest rate on home loans to external bench mark, which is the normal practice in advanced economies, is getting accepted in our country also. The Reserve Bank of India has been suggesting Banks to link their lending rates to external bench marks such as Repo Rate or Treasury Bills.
Repo rate is the rate at which the central bank of a country (Reserve Bank of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control cash flow in the economy and to control inflation. It is reviewed periodically, once in a quarter and altered considering various relevant factors.

When there is a decrease in the Repo rate, the banks get funds at a cheaper rate and if Repo rate is increased, the cost of funds goes up for Banks.

As Repo rate reflects the proper interest rate movement in the economy and decided by the Central Government, if lending rates, especially the long term home loans are linked to Repo Rate, it can bring in more transparency in fixing interest rates and also help in for proper transmission of increased or decreased interest rate to the borrowers.

RLLR product from SBI:
State Bank of India, the largest lender in the country has introduced Repo rate Linked Lending Rate (RLLR) with effect from July 1, 2019 and also has continued its MCLR linked home loans.
Under the RLLR linked home loan, considering the present Repo rate of 5.75%, SBI has announced that it will have base spread of 2.25% above Repo rate, which makes the RLLR as 8%.

For regular home loan up to Rs. 75 lakh, with certain conditions, SBI has announced 40 base points (0.4%) as margin, which makes the effective interest rate of 8.4% pa.

It may be noted that whenever Repo rate is tweaked by RBI, the RLLR of SBI will also vary keeping the same base spread of 2.25%. As per the notification issued by SBI, the margin of 40 base points above RLLP, remains constant for the entire loan repayment period, thus assuring full transparency in charging interest rates.
SBI has also clarified that as and when Repo rate is changed by RBI, the RLLR will automatically change to new rate and shall be applicable to all home loan accounts from the first day of subsequent month.

So the home finance sector is at the cusp of another era of transparent mechanism
followed by Banks in fixing interest rates on home loans and also swift transmission of change in the interest rates to reach the existing borrowers.

The author is Managing Director of PropSeva ® (Abhrant Property Counseling Services Pvt. Ltd.), and can be contacted on 91 93412 13530 or email: