From October 1, all banks will mandatorily link their new floating rate personal or retail loans, and floating rate loans to MSMEs, to an external benchmark. In picking a benchmark, banks have so far shown preference for the repo rate over other external benchmarks such as the 3-month or 6-month Treasury Bill yield. The repo rate is set by the Reserve Bank of India. It is the rate at which banks borrow from the central bank.
What Are Benchmarks?
All loans sold by banks are linked to a benchmark rate, which is the lowest rate at which a bank can lend. Over the benchmark, banks apply a credit spread. The spread is determined by such factors as the borrower’s gender, income source and credit score, and the size of the loan required. For example, a female, salaried borrower with a credit score of 800 and applying for a home loan of Rs. 30 lakh will typically pay the lowest interest rate. The benchmark and the credit score constitute the final rate of interest at which a loan is granted.
So What Changes?
Since April 1, 2016, floating rate loans from banks were linked to the MCLR – a benchmark set internally by banks based on their cost of funds. The RBI noted that despite the shift from base rate to MCLR, interest rates on loans were not dropping sufficiently in tandem with the RBI’s repo rate cuts. As per one report, while the repo rate fell from 6.50% to 5.75% between January and July 2019, the average weighed reduction in loan prices fell a mere two basis points from 9.79% to 9.77%. Similar concerns had prompted the RBI to prompt banks to move to external benchmarks by April 1 this year. However, banks had asked for more time.
How Will This Affect Rates?
Interest rates on bank loans will now be linked to one of the three external benchmark options provided by the RBI. Banks have so far preferred the repo rate, and hence their new loans will be linked to the repo rate. For example, the State Bank of India has relaunched its repo-linked loans on October 1. Its new benchmark – the EBR – is currently at 8.05%, which is 265 basis points above the repo rate (currently at 5.40%). The lowest credit spread on this benchmark is 15 basis points, and so their cheapest home loan rate currently is 8.20%. Now, since this loan is linked to the repo rate, any adjustment to the repo rate will immediately reflect in the loan rate at the next rate reset date. And therefore, a falling repo rate would mean an immediately lower loan rate. However, this also means that when interest rates rise, the rate hikes will be immediately passed on to consumers at the reset.
Which Banks Have Announced Repo-Linked Loans?
Several public sector banks have announced repo-linked loans. Apart from the SBI, these banks include Bank of Baroda, Allahabad Bank, Canara Bank and India Overseas Bank. However, private banks are yet to announce their new benchmarks as of October 1.
What Can Consumers Expect?
Consumers can expect cheaper loans home, car, education and personal loans. They can expect their loan rates to fall in tandem with the repo rate and pinch their pockets less. However, they should also be prepared for their loan rates to rise as sharply during high inflation periods as they had fallen during low inflation periods.
Will Existing Customers Benefit?
The new benchmarking regime applies to new bank loans only. Existing bank loans will continue as per the terms of the loan agreement till the end of the loan tenure. However, existing customers can explore the option of transferring their loan (be it MCLR-linked or base rate-linked) to a repo-linked loan. The repo linking will not impact new loans taken from NBFCs and HFCs since these will not be linked to an external benchmark.
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