Are External Benchmark-linked Loans worth it? Or Time for Fixed-Rate Loans?
MAS Team | 20 September 2019
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The Reserve Bank of India has asked banks to link their floating rate loans with external benchmarks. Up until now, banks formulated an internal benchmark rate called as the base rate or its newer version called MCLR (marginal cost-of-funds-based lending rate), to determine the loan rate chargeable to the customer.
The change in benchmark will align loan rates with the broad debt market, moving away from the control of the bank.
External benchmarking was introduced after the RBI noticed that banks were not reducing loan rates in line with falling interest rates in the economy.
Because the banks were free to decide the loan rate, using the base rate/MCLR, the rate reductions were minimal and unsatisfactory.
The banks were obviously looking to earn higher income by keeping loan rates high even when its own cost of borrowing had reduced far greatly.
How will it work?
Effective 1 October 2019, banks are mandated to link their floating rate loans to external benchmarks like repo-rate, treasury bill rates, or any other external benchmark.
New Loan rate = (Benchmark rate + lending rate) + Risk spread
Benchmark rate could be repo rate, 3-month treasury-bill rate or other.
Lending rate will be fixed and covers the operational expense and income of the bank
Risk spread will be determined on the loan amount and credit score of the borrower.
The RBI has allowed existing borrowers under MCLR to move to the external benchmarked-loans, but inexplicably has allowed banks charge some fees for this.
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 benchmark repo or t-bill yield.
A few banks have already rolled out their repo-linked home loans for customers. Public sector behemoth State Bank of India recently withdrew its repo-linked loan, as it plans to launch a better version of a fixed-floating rate loan soon.
Floating rates linked to a constantly changing benchmark would mean your equated monthly instalments (EMIs) would also fluctuate. Some banks may choose to keep the loan tenure constant while allow the EMI amount be dynamic, or the other way round.
This will only be known once most banks announce their own repo- or t-bill-linked loans in the market.
On the face of it, external benchmark linked loans are more transparent than MCLR loans, and especially beneficial in a scenario of falling interest rates.
Many borrowers are stuck paying 10-11% interest today, even with a good credit score, because their loan rates were based on old base rate/MCLR. This problem will be solved under a repo rate-linked loan.
The downsides
There are a few concerns regarding the way repo-linked loans would be structured. Earlier, under the MCLR-system, banks would quote the final loan rate using MCLR rate + risk spread. Borrowers would hunt for the lowest MCLR rate offered by banks to find the best deal.
Under the new system of external benchmarks, banks have several different external benchmarks to link their various loan products. Home loans could be linked to the repo-rate, vehicle loans could be linked to the 6-month T-bill rate etc.
Different benchmarks means some loans (like T-bill linked loans) would see regular fluctuation in the EMIs, while others (like repo-linked loans) would not fluctuate much.
Secondly, banks are charging a certain percentage over the external benchmark rate, as overhead costs. This gives us the ‘lending rate’. Although the repo rate is 5.60% right now, the bank may charge a fixed 2%-3% over it. This gives us the lending rate which is 7.60%-8.60%.
Third, there will be a risk spread depending on the credit worthiness of the borrower and size of loan. This will add another 1% to the loan rate.
There is a possibility that the new type of loan rate could end up being higher than current MCLR rates.
The new loan rates could actually increase EMI costs for borrowers if the underlying benchmark rate moves up. Considering interest rates are already at lows, any reversal would harm repo-linked loans more than others.
Borrowers should, therefore, wait for some time to check how the new loan rates work. They may also like to consider whether to go for fixed-rate loans because there scope for fall in interest rate any further is minimal. The chances are high that the rates would stay at this level or rise.
Dear Investor,
In case of any grievance / complaint :
In case of any grievance / complaint :
- Please contact Compliance Officer Shraddha Mhatre at [email protected] and Phone No. - 91-22-35131664.
- You may also approach CEO Debashis Basu at email- id [email protected] and Phone No. - 91-22-35131664.
