The Reserve Bank of India (RBI) is looking to put in place a framework for resetting interest rates for floating-interest loans. Lenders will have to clearly communicate with borrowers on increasing the tenure for equated monthly instalments (EMIs), switching to fixed-rate loans, etc. Saikat Neogi takes a look at what forced the RBI’s hand and how borrowers could benefit
Conduct framework for lenders
When the interest rate rises, banks increase the repayment tenure of a loan, instead of increasing the EMI outgo, sans proper communication and consent from the borrower. Thus, borrowers may not immediately feel the pressure of rising rates, but the longer tenure means the total interest payout, especially on a new loan, rises significantly. The repo rate increasing by 250 bps over May 2022-February 2023, meant the repayment tenure for many borrowers has now gone beyond their retirement age.
Servicing a loan after retirement may be difficult for many. Mandatory borrower consent can help the borrower take an informed decision on a higher EMI outgo vis-a-vis a longer loan tenure. While the RBI says banks will get to decide, it has emphasised that they must consider borrower’s age and repayment capacity.
Transmission of interest rates
For faster transmission of interest-rate action, the central bank had introduced the external benchmark-based lending rate regime in October 2019 as the transmission in the Marginal Cost of Funds based Lending Rate regime (introduced in April 2016, replacing the earlier base rate system) was not satisfactory.
Banks decide their own spread during the term of the loan over the external benchmark rate, based on factors like the borrower’s credit score. The introduction of the repo rate-linked loans has made the pricing of retail loans more transparent and the reset period for the interest rate as well as the EMI is three months.
If there is a cap on the tenure, there are two ways banks can deal with the situation—they can increase the EMI or seek part payment from the borrower to keep the EMI the same.
What should borrowers do when rates rise?
When interest rates rise, home loan borrowers should ideally opt for pre-payment in addition to regular EMIs to reduce the outstanding tenure and overall interest significantly. Pre-payment can be done in tranches without compromising the borrower’s existing investments for achieving crucial financial goals. If the borrower does not have excess funds, then he can increase the EMI, which will help him to reduce the overall interest burden. While lenders do not charge any pre-payment penalty on floating rate home loans, they charge prepayment interest, which is simple interest based on principal outstanding and the reference date of pre-payment.
Another option to lower the interest rate burden significantly and prevent a longer tenure is to opt for loan refinancing, a process of replacing an existing loan with a new loan that has better terms such as a lower interest rate and shorter tenure. However, borrowers will have to pay a processing fee of 0.5% of the loan amount. In fact, loan refinancing is an ideal option for those who borrowed recently because the interest component of the EMI is much more in the initial years of the loan and a rise in interest rates pushes up the total interest payout significantly.