Although the Reserve Bank of India (RBI) has effected several reductions in the repo rate (the rate at which banks borrow from the central bank), lending rates have not witnessed a corresponding change. Home buyers, hence, are often eager to know why this happens and how interest rates are charged by banks and housing finance companies (HFCs). This article deals with how interest on home loan has been charged by housing finance companies as well as banks.
On what basis are home loan interest rates charged by housing finance companies?
Benchmark Prime Lending Rate
HFCs are regulated by the National Housing Bank Limited (NHB), a subsidiary of the RBI. The funding of HFCs is different from banks. So, the basis of charging interest on home loans granted by HFCs, is altogether different from the one adopted by the banks. These companies base their actual lending rates against an internal benchmark rate, which is called the Benchmark Prime Lending Rate (BPLR). Interest rates for all loans are calculated with reference to this rate. The BPLR is generally the highest rate that the HFC charges. So, a majority of the home loans are given at a rate below this PLR.
What are the drawbacks of the PLR regime?
As no borrower knows the lowest rate that the best customer gets, this basis is non-transparent. Moreover, these lenders normally do not change their PLR as frequently as the banks change their rates. In order to entice and acquire new customers, the HFCs offer greater discounts on their PLR to them, which may seem unfair to the existing customers, who are locked-in at higher rates. The existing borrower will get the benefit of lower rates, only when the lender reduces its PLR, which does not happen frequently.
Should borrowers opt for a housing finance company or a bank?
Hence, borrowers with good credit scores, should avail of home loans from banks, rather than from HFCs. In case you wish to avail of the rate that is offered to new customers, you are required to pay a switching fee.
The question that arises then, is: Why do people turn to HFCs. In majority of the cases the borrowers have some problems, either with the documents of the property or their income proof or a bad credit rating. As lending to such borrowers carries a higher risk for the lender, a higher rate of interest as compared to banks, is justified.
How are home loan interest rates charged by banks?
The PLR and base rate regime
Earlier, banks also used to lend on the same basis followed by HFCs – i.e., the PLR. As this basis of lending was not transparent or consumer-friendly and to bring in transparency in the lending rates, the RBI introduced the concept of ‘base rate’, for computing the lending rates, from July 2010. The base rate is a rate below which the banks are not allowed to lend, even to the best of the borrowers. The purpose of introducing the base rate concept was, to bring in transparency in lending and to ensure that the banks pass on the reductions in the repo rate to the customers, quicker than what was happening under the PLR regime. The first purpose was served, as the base rate served as the bottom rate. So, a borrower knew exactly what premium he was paying over the best of customers, who could get the home loan at the base rate.
What are the drawbacks of the base rate regime?
However, banks were not quick in passing on the benefits of reductions in the repo rate. Banks also devised ingenious ways to compute their base rates differently and it was not transparent. The base rate was supposed to be based on the cost of the funds of the bank. However, as the banks had portfolios of old deposits and borrowings carrying higher rates, this resulted in very marginal reduction in their base rates, every time the RBI reduced its repo rate. This was evident from the fact that while the RBI reduced the repo rate by 175 basis points between January 2014 and October 2016, the banks reduced the base rate by only 50 basis points to 75 basis points, thus, denying consumers the benefits of reduction in the repo rate.
What is the MCLR regime?
As the base rate concept did not achieve the desired results and to ensure that the banks pass on the benefits of reduced repo rate and cost of borrowings to the consumers, quicker than what was actually happening, the RBI made it mandatory for all banks to link all loans to their marginal cost of borrowing, for different tenures. With this, banks were supposed to work out the marginal cost of funds-based lending rate (MCLR) for different tenures like overnight, one month, three months, six months and twelve months. This was unlike the base rate, which was used for lending by the banks for different tenures, without looking at the corresponding borrowing based on tenure. Under the MCLR the interest rates for home loans did not change with each change in the MCLR of the bank, as the banks were allowed to have a reset period of a maximum of one year.
External rates as benchmarks and repo rate-linked home loans
As this also did not get the desired results, the RBI made it mandatory for all banks to benchmark all their loans against a rate that was not computed internally but benchmarked against an external rate, from October 1, 2019. Banks now have the option to benchmark their lending rates against any of the external benchmark like:
a) RBI repo rate
b) Three-month yield of government of India treasury bills announced by the Financial Benchmarks India Private Ltd (FBIL)
c) Six-month yield on treasury bills of the government, as announced by FBIL and
d) Any other benchmark published by the FBIL.
With external benchmarking, any reduction in the repo rate will be transmitted quickly to the borrowers. Moreover, the review period has also been brought down from one year under the MCLR to two months under externally-benchmarked lending rates (EBLR). This is beneficial for the borrower when interest rates reduce but will act against the borrower when rates increase, as the transmission of rates will happen sooner, at the most within two months of a change in the RBI’s repo rate.
Should home loan borrowers switch to externally-benchmarked lending rates?
Existing home loans taken under the PLR, base rate and MCLR regimes, shall continue to be governed by the respective regime till the loans are fully repaid, unless the same have been switched to EBLR. Existing borrowers can switch to EBLR without any charges, if their loan was not subject to any prepayment charges. Even if your home loan is subject to a prepayment charge, you can still switch to the EBLR, if you wish. Whether one should switch to the EBLR or not, is a tricky question, as interest rates will change quicker under this regime, even when the interest rate cycle reverses. It is difficult to predict how long the low rates will last and when it will reverse.
(The author is a tax and investment expert, with 35 years’ experience)