RBI MPC: Das calls for greater transparency in floating-rate loans

The RBI Governor announced putting in place a transparent framework for re-setting of interest rates on floating rate loans.

Batting on the side of bank customers yet again, the RBI Governor on August 10 announced putting in place a transparent framework for resetting of interest rates on floating rate loans.

Shaktikanta Das mentioned four key focus areas: lenders must clearly communicate to borrowers when resetting the loan tenure and/or EMI, provide options for switching to fixed-rate loans, or foreclosing loans, disclose all charges related to such a switch, and communicate all key information to their borrowers.

Floating rate loans

In a floating rate loan, the interest rate is linked to a benchmark rate that is market–determined. All retails loans sanctioned by banks from October 1, 2019 have been linked to the repo rate. The loan rate of interest for such loans is typically set as repo rate plus spread plus credit risk premium. Home loans, personal loans, and car loans are the three main retail loan categories that have floating interest rates.

While the introduction of the repo rate-linked loans since October 2019 has made the pricing of retail loans more transparent, banks’ communication with borrowers on any loan-related aspects leaves room for improvement. Experts say that while banks do keep their borrowers informed, the communication can be made more effective and transparent.

More transparency needed

For example, if the interest rates were to go up today, the default option for a bank will be to extend your loan tenure rather than hike the EMI (equated monthly instalment). While banks have to inform their customers about such changes, there have been instances where customers have been caught unawares.

Commenting on the RBI announcement, Adhil Shetty, CEO, Bankbazaar.com says, “The RBI has at various stages insisted that regulated entities such as banks communicate clearly to consumers, especially charges and key facts. While banks have responded very well to this, some work may still need to be done. In the last year, as the repo rate moved from 4.00 percent to 6.50 percent in just a few months, we have come across instances of some shocking extensions in home loan tenors. For example, someone who had borrowed for 20 years suddenly saw a 30-year jump in their tenure.”

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According to Atul Monga, CEO and Co-Founder, Basic Home Loan, a home loan fintech platform, the RBI Governor's statement likely pertains to the need for banks to communicate more effectively with their customers regarding changes in interest rates, loan tenure, and EMI. This enhanced communication aims to ensure that borrowers have a clear understanding of how these changes work and how this might impact their financial obligations.

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Different benchmarks over time  

To add to the confusion is the fact that not all existing retail loans are linked to the repo rate.

It is only from 1 October 2019 onwards that all floating rate retail loans have been linked to the repo rate. Loans issued before that were linked to the MCLR or the marginal cost of funds-based lending rate. MCLR-linked loans were first introduced in April 2016, replacing the earlier base rate system. Borrowers have the option to switch, say from an MCLR-linked loan to a repo-linked loan.

Also, even when the repo rate or the MCLR changes, the impact on your loan rate may not be felt at the same time.

Here’s an example from Shetty. “Say, your MCLR-linked loan is sanctioned on September 1, 2018 with a reset period of 1 year. The prevailing MCLR on that day is 10 percent p.a. This will be your interest rate for one year. If the rate falls to 8 percent during the year, this will not impact your rate. It’s only on Sep 1, 2019 that the interest rate will change to 8 percent, that is, the prevailing rate on that date,” explains Shetty.

It works somewhat differently for loans linked to the repo rate. “The reset period for the interest rate as well as the EMI for such loans is three months at most. The interest rate can be reset anytime until then. This is much shorter compared to an MCLR-linked loan where the reset period is typically 12 months,” says Shetty.

He, however, highlights that the one-year MCLR is not the de facto MCLR for home loans. Many lenders offered home loans with 6-month as well as 24-month MCLR.

Also read: Borrowing from a digital lending app? Spot the red flags first

Switch between floating and fixed rates

The RBI has also asked banks to give customers the option to switch from floating to fixed rate loans. But with only a few banks offering fixed rates in case of home loans, and that too, at rates significantly above their respective floating rates, customers may not exercise this option.

“As a product, fixed rate loans are not as popular because they have a much higher interest rate and a prepayment penalty. Unless the loan is availed when the interest cycle is at the rock-bottom, most customers may not want to opt for it as they will miss the benefit of falling rates. Also, as the lender has to bank risk for 20 years or more on an average, the fixed rate loans will continue to be on the higher side,” says Shetty.

But he feels that with the RBI saying that lenders should provide fixed loans to borrowers, one may see some innovations here.