Many people dream of owning their own home. Home loans make this dream a reality by allowing us to spread the cost of buying a home over several years. What is meant by the strange term “home loan spread” and how does it impact borrowers, though?
See also: Home loan: meaning, types, benefits, how to apply, interest rates, EMI calculator
What is home loan spread?
The home loan spread is the additional cost you pay as a homebuyer over and above the RBI-determined repo rate to obtain a loan from a bank. Simply put, it is the difference between the base rate (the bank’s minimum interest rate) and the interest rate charged to you. Banks use this spread to stay profitable while responding to changes in policy rates. Simply put, it is the markup added by the lender to a base rate to determine your final interest rate. This base rate could be the bank’s internal benchmark or an external reference rate, such as the RBI repo rate in India.
Understanding the spread components
Imagine you’re looking to borrow money to buy a home, and the bank tells you about something called the “spread.” It’s like a hidden part of the interest rate you’ll pay, made up of two main parts:
Base rate
This is the starting point for your interest rate. It covers the bank’s basic costs of doing business, like running their offices, paying staff, and making a profit.
Risk premium
This part of the spread is all about you – the borrower. It’s based on how risky the bank thinks it is to lend you money. Factors like your credit score, how reliably you’ve paid debts in the past, and how stable your income is all come into play here.
Now, when you add up the base rate and the risk premium, you get the total spread. This is the extra amount on top of the base rate that determines your final interest rate. So, the spread isn’t just one fixed thing – it’s a combination of what the bank needs to cover its costs and how risky they think you are as a borrower.
Why is the interest rate higher than the base rate?
When you take out a home loan, you’ll notice that the interest rate you’re offered is usually significantly higher than what the bank refers to as the “base rate.” This base rate serves as the starting point for your interest rate. It is set by the bank and covers their basic expenses and profits. Banks add this additional amount, known as the “spread,” to the base rate. They do this for a variety of reasons.
Covering risks and making money
Banks face some risk when lending money. They must ensure that they are adequately protected in the event that borrowers fail to repay their loans. So, a portion of the extra money you’re paying goes toward covering this risk.Â
Responding to market changes
While the base rate may remain constant for a while, factors such as the RBI’s policies can influence it. For example, raising the repo rate, which is the rate at which banks borrow money from the RBI, can raise the cost of lending. So, to maintain their profits, banks may adjust their spread accordingly. It’s all about ensuring they’re still profitable while also adapting to market changes.
Factors affecting the spread
Credit score
Your credit score is like your financial report card. If you’ve got a high score, it tells the bank you’re good at managing money and paying back debts. This means they see you as less risky, so they might offer you a lower spread and a better interest rate.
Income and job stability
Banks like to see that you’ve got a steady income and a stable job. It shows them you’re reliable and can keep up with loan payments. If you’ve got a stable income history, they might give you a break on the spread.
Loan amount and down payment
If you’re borrowing less money or putting down a bigger down payment, it’s less risky for the bank. That’s because you’re investing more of your own money upfront. So, they might cut you some slack on the spread.
Type of loan and length of loan
Some loans come with special features or longer terms. While these can be helpful, they might also come with higher spreads. So, it’s important to weigh the benefits against the costs.
Negotiation
Negotiation is sometimes possible. Depending on your financial situation and the lender you’re working with, you may be able to negotiate the spread slightly. It doesn’t hurt to ask!
Fixed vs floating spreads
| Aspect | Fixed spread | Floating spread |
| Interest rate | Constant throughout the loan tenure | Can change based on market and bank decisions |
| Stability | Offers stability in payments | Provides flexibility, but payments can vary |
| Market fluctuations | Not affected by market changes | Can be influenced by market conditions |
| Policy rates impact | Unaffected by changes in policy rates | Can adjust based on policy rate changes |
Impact on borrowers
Reduced EMI burden
Meera’s story illustrates how negotiating a lower spread on her home loan resulted in significant monthly savings. Initially, she obtained a loan with a 1.5% spread, resulting in a monthly EMI of ₹20,848. She was able to reduce her spread to 1% by using good credit and negotiation skills. The reduced spread resulted in a 7.5% interest rate and a monthly EMI of ₹20,140. The small difference resulted in monthly savings of ₹708. Her 20-year loan resulted in a total savings of ₹1,68,960, demonstrating the tangible impact of lower spreads on monthly affordability.
A lower spread results in lower Equated Monthly Instalments (EMIs) and reduced interest payments over time. Borrowers benefit from consistently lower spread rates as the repo rate falls.
Lower total loan cost
Rohan’s experience shows how negotiating a lower spread can significantly lower the total cost of a home loan. Initially, he took out a ₹50 lakh loan for 15 years with a 2% spread and an interest rate of 9.25%. Over the loan term, his total interest payment was ₹8,38,212. Rohan was able to reduce his spread to 1.5% by leveraging his stable income and negotiating skills. Consequently, his interest rate dropped to 8.75%, resulting in a significant decrease in his total interest payment to ₹7,46,418. Securing a lower spread is crucial for minimising loan costs, as shown by the substantial savings of ₹91,794 over the loan’s duration.
Borrowers with high credit scores and stable incomes typically secure the lowest spread rates, which remain constant throughout the loan tenure.
Improved affordability
Priya’s situation indicates how negotiating a lower spread can improve affordability and help borrowers achieve their homeownership goals. Initially, she sought a ₹25 lakh loan, but could only afford a ₹15,000 monthly EMI. With a 2% spread, she was limited to a loan of ₹21.8 lakhs at a 9% interest rate. Priya’s qualifying loan amount increased to ₹23.4 lakhs after successfully negotiating a lower spread of 1.5%. This adjustment allowed her to bridge the gap between her desired loan amount and her financial constraints, bringing her closer to realising her dream of owning a house.
FAQs
Spread is not a hidden cost. It's part of the interest rate you pay and is usually disclosed upfront.
Historically, the spread in India has ranged between 1.5% and 2%. In March 2020, the spread rate was nearly 3.50, but it has now decreased to 1.95.
Usually, no specific documents are needed. However, you can negotiate more effectively if you have your credit score report and proof of income on hand.
When you choose a floating rate for your home loan, it can be difficult to predict future interest rates. Because of the uncertainty surrounding market fluctuations, interest rates may rise significantly, potentially adversely affecting borrowers. However, it is critical to remember that you have the option of switching from a fixed to a floating rate, or vice versa, during the loan term.
To minimise the impact of spread changes on your home loan, regularly monitor market conditions and interest rate trends.
The spread remains constant throughout the loan tenure. For instance, if you start with a low spread rate, it remains unchanged even if the repo rate fluctuates.
New borrowers benefit from the current low spread rate, starting their loans at a lower rate compared to pre-pandemic borrowers. Is the spread a hidden cost?
What's the typical range for the spread?
What documents do I need to negotiate the spread?
Is it better to opt for a fixed or floating spread on a home loan?
How can I minimise the impact of spread changes on my home loan?
Is spread fixed throughout the whole tenure?
How do new borrowers fare in comparison to pre-pandemic borrowers regarding the current low spread rate on home loans?
| Got any questions or point of view on our article? We would love to hear from you. Write to our Editor-in-Chief Jhumur Ghosh at jhumur.ghosh1@housing.com |
