Have you ever paused to think about how banks fix their interest rates? Not all borrowers know that the interest rate charged by banks comprises two components: Base rate and spread.

Base rate

Base rate is the minimum rate of interest below which banks cannot lend. The system of base rates was introduced on July 1, 2010, replacing the previous Benchmark Prime Lending Rate (BPLR). Individual banks fix the base rate based on the broad guidelines issued by the RBI. Base rate calculations are largely transparent and are common for all borrowers. The only exceptions where banks may lend below the base rate are export credit and farm loans.

Spread

To arrive at the final lending rate, banks add some percentage points to the base rate. These additional percentage points are called the spread. For example, if the loan interest rate is 10.25% and the base rate is 10%, 0.25% is the spread. Banks calculate the spread based on their profit requirement, operating costs, risk and credit loss. Spread is decided at the time you avail of a loan and depends on factors, such as loan type, credit profile, etc. All borrowers benefit when banks announce a cut in base rate, but this is not the case when banks cut the spread.

Suppose your bank announces a rate cut of 0.25% in spread, while the existing interest rate is 10.50% and the base rate is 10%. The move will benefit new customers only as they will have to pay 10.25% while the existing ones will continue paying 10.50%.

Cut in base rate or spread: Which is better?

As base rate is more transparent than spread and is reviewed periodically, a reduction in base rate is more beneficial for customers. Spread is not uniform for all customers and is an internal decision of the bank while fixing the final lending rates. A cut in spread rate benefits only new customers and banks use spread as a tool to attract more customers.

BPLR

All floating rate home loans are linked to either base rate or BPLR. BPLR has now lost relevance as it is applicable only to loans availed before July 1, 2010. The BPLR system was introduced in an effort to bring in transparency in lending, but failed to yield desired results, as banks could still lend below the BPLR. As a result, banks started lending below BPLR to their preferred customers. While fixing BPLR, banks tended to not disclose to borrowers the factors taken into consideration while fixing the rate. Thus, variations in BPLR were very wide and, sometimes, the difference was as high as 4%.

Switching from BPLR to base rate system

If you have taken a home loan before July 2010, your loan will be under the BPLR system. As a result, you may be paying a higher interest than the current rates of the bank. This is because RBI allows customers to continue under BPLR system until maturity. However, if a borrower under the BPLR system wants to switch to the new arrangement, he can opt for it by paying a switch-fee of around 2% of the principle outstanding.

A borrower should keep some factors in mind while comparing rates offered by different lenders. Firstly, shop for the best interest rates. Secondly, choose the lender offering lower spread. Suppose Bank A and Bank B are offering loan at 10%. Bank A is offering loan at 1% above the base rate of 9% and Bank B is offering 0.5% above base rate of 9.5%. The borrower is better off choosing Bank B as it would be under pressure to cut its base rate whenever there is a drop in interest rates or guidelines by the RBI to that effect. The spread is likely to remain unchanged, thereby lowering the final lending rate.

The writer is CEO, BankBazaar.com