The main purpose behind repo-linked loans introduced in 2019 was to pass on the benefits of falling interest rates to borrowers. But there is a chance that despite taking a repo-linked loan, your equated monthly installment (EMI) could be higher than other borrowers from the same bank. The answer lies in the risk premium the bank charges you.
Despite interest rates being at a 15-year low, having multiple loans can affect your chances of getting low rates. Even if you make timely repayments, your credit score would be lower due to excessive borrowing. This will lead to higher interest rates being charged by the bank for a home loan. Some banks are now arriving at interest rates using risk-based pricing on floating rate loans.
What is risk-based pricing?
Loans linked to external benchmarks such as repo rates are transparent. But they also take into account a borrower’s credit-worthiness. Here’s where the risk premium comes in. As per RBI’s rules, banks look at your credit scores and decide how much risk premium they want to charge you. So, the lower your credit score, higher is your credit mark-up. Therefore, bad credit scores attract higher interest rates.
It is basically preferential pricing that is being offered by some of the banks to reward the borrower’s good credit behaviour with low interest rates. Banks are considering the past credit history of the loan applicant using third-party credit scores to derive default probability.
For instance, if you are deemed to have a higher probability of default due to excessive borrowing in a bank’s credit profile, you are now charged an additional premium on interest rates due to higher credit risk.
Which banks have adopted to risk-based pricing?
Risk based pricing has been adopted by Bank of Baroda, Union Bank of India and Syndicate Bank among others. They use credit scores from Credit Information Bureau (India) Ltd (CIBIL) to price new home loans. Further, SBI derives the risk grade of borrowers based on internal assessment and credit score inputs from credit bureaus. At present, Union Bank of India charges 10 bps more to customers with credit scores below 700.
Gaurav Chopra, founder CEO of IndiaLends, says, “Risk-based pricing has been happening with private/multinational banks for a long time. These are essentially personalised credit rates that they're offering to borrowers.”
Can bank increase the risk premium if interest rates fall?
Yes, banks can increase the risk premium for new borrowers if interest rates continue to fall. For instance, interest rates have declined sharply since the Reserve Bank of India’s (RBI) cumulative 115 basis points rate cut after the COVID-19 outbreak-induced lockdown in March. A basis point is equal to one-hundredth of a percentage point.
But, in May, State Bank of India raised the premium it charges over its external benchmark rate (EBR) by 20 bps for floating rate home loans. Similarly, in August, Bank of Baroda (BOB) increased the risk premium it charges on repo-linked loans from new borrowers. The risk premium went up by 15 basis points (bps) for the borrowers with higher credit scores and 50 bps for lower credit scores.
If your lending bank increases your risk premium charges on repo-linked loans by 50 bps, your equated monthly instalment (EMI) will be higher by around Rs 2,000 a month.
What are the factors leading to increase in risk premium?
The COVID-19 pandemic has impacted the income flow of many families. This has led to an increase in credit risk for banks. “Banks are also making provisions for non-performing assets (NPAs) that could arise after the moratorium ends on August 31,” says a financial advisor requesting anonymity. Taking these factors in to consideration, banks are raising the credit risk premium on repo-linked loans.
The half-yearly Financial Stability Report (FSR) from Reserve Bank of India indicates that the gross NPA ratio of all scheduled commercial banks may shoot-up to 12.5 per cent in March 2021 from 8.5 per cent in March 2020 under the baseline scenario. If the macroeconomic environment deteriorates further, the gross NPA may escalate to 14.7 per cent under the very severely stressed scenario.