The banks offer/charge certain ‘rate of interest’ on deposits and loans. The rate of interest charged by a financial institution for lending money is known as ‘Lending Rate‘.
Loan Lending Rate = Benchmark Rate + Margin Rate
The method to arrive at Lending Rate has changed drastically over the last decade or so. Banks & Financial Institutions have been using the below Lending Rates to fix the interest rates on loans;
- BPLR (Benchmark Prime Lending Rate)
- Base Rate (Base Rate replaced BPLR w.e.f July, 2010)
- MCLR – Marginal Cost of Fund based Lending Rate (MCLR has been in effect since April 1, 2016.)
- RLLR – Repo Linked Lending Rate (available w.e.f 1st Jul, 2019)
The interest rate on retail loan (mostly) has two components – the benchmark rate i.e., repo-rate and the spread (profit margin). The spread is calculated based on the borrower’s credit score, income source, and loan size.
Loan Lending Rate = Repo Rate + Margin Rate
So, any cut or increase in rates (especially key rate like Repo Rate) by the RBI now gets transmitted to the bank customers immediately. But there has been lack of transparency on how this is being executed.
According to the RBI, several consumer grievances have been received in relation to elongation of loan tenor or increase in EMI amount with regard to EMI-based floating rate personal loans, without proper communication or consent of the borrowers.
In a welcome move, the RBI has recently come up with latest floating rate reset rules (2023) on loans. These new norms are applicable on all existing and new floating rate loans (EMI based) taken by individuals, suitably by 31st December, 2023.
Latest Floating Rate Reset Rules on EMI based Loans | RBI’s new guidelines
Below are the key points of RBI’s notification;
- At the time of sanction of EMI based floating rate loans, the financial entities are required to take into account the repayment capacity of borrowers to ensure that adequate headroom/ margin is available for elongation of tenor and/ or increase in EMI, in the scenario of possible increase in the external benchmark rate during the tenor of the loan.
- At the time of sanction, the financial institutions shall clearly communicate to the borrowers about the possible impact of change in benchmark interest rate on the loan leading to changes in EMI and/or tenor or both. Subsequently, any increase in the EMI/ tenor or both on account of the above shall be communicated to the borrower immediately through appropriate channels.
- At the time of reset of interest rates, the lending institutions shall provide the option to the borrowers to switch over to a fixed rate as per their Board approved policy. The policy may also specify the number of times a borrower will be allowed to switch between the Rates during the tenor of the loan.
- The borrowers shall also be given the choice to opt for (i) enhancement in EMI or elongation of tenor or for a combination of both options; and, (ii) to prepay, either in part or in full, at any point during the tenor of the loan. Levy of foreclosure charges/ pre-payment penalty shall be subject to extant instructions.
- All applicable charges for switching of loans from floating to fixed rate and any other service charges/ administrative costs incidental to the exercise of the above options shall be transparently disclosed in the sanction letter and also at the time of revision of such charges/ costs by the REs (Registered Entities) from time to time.
- REs shall ensure that the elongation of tenor in case of floating rate loan does not result in negative amortization.
Impact of RBI’s new rules on EMI based Floated Interest Rate Loans
Let’s understand how these new norms impact the individual borrowers;
Type of Loans
- The above instructions are applicable to all EMI based floating interest rate retail loans taken by individuals.
- The fixed rate loans do not come under the purview of the above circular.
- Bullet Repayment Loans are not considered in the notification.
- Home Loans, Loan Against Property, Auto Loans, Micro-finance Loans, Digital Loans and Education Loans that are floating rate based come under the ambit of these new regulations.
Type of Lending institution
The below financial institutions need to abide by these new rules;
- All Scheduled Commercial Banks
- Regional Rural Banks
- Primary (Urban) Co-operative Banks
- State Co-operative Banks and District Central Co-operative Banks
- Non-Banking Financial Companies (NBFCs)
- Housing Finance Companies (HFCs)
Impact on Loan Eligibility
As per the new rules, the lending institutions has to assess the repayment capacity of the borrowers while sanctioning the loans. This means, even if there are huge hikes of lending rates in the future, the lenders should make sure there is an adequate headroom or margin is available for the elongation of tenor and/or increase in EMI. Given this kind of criteria, the lenders may sanction loans under tight underwriting conditions and there is a high possibility that the bankers will either sanction the loan at a higher margin or reduce the loan eligibility amount.
Option to choose Fixed Rate
If you have a floating rate loan, you are now allowed to shift to fixed interest rates during the interest rate reset. Your lender will now inform you as to how many times you are allowed to make such switches during the loan tenure.
But do keep in mind that the interest rates on fixed rate loans are higher than the floating rate loans. Also, when interest rates fall, you do not get the benefit of rate reductions.
“All applicable charges for switching loans from floating to fixed rate should be transparently disclosed in the sanction letter and also at the time of revision of such charges/costs by the lenders from time to time.” – RBI
More Fixed rate Loan products
As it is mandatory for the lenders to provide an option to the borrowers to shift to fixed rate during rate reset, all floating interest rate loan products now need to have their counter-part Fixed rate loan products. Hence, we may now see introduction more fixed rate loan products in the lending market.
Among retail loan products, it’s mostly home loans where the interest rate is floating. Banks charge fixed interest rates on auto and personal loans. With the introduction of these new rules, banks may offer fixed rate loans across different types of loans.
Options on Rate Reset
As per the RBI’s new guidelines, the financial entities should give below options to the borrower in the event of reset of the floating rate of interest;
- Enhancement/ reduction in EMI
- Elongation or contraction of loan tenor
- Combination of above (both) options
- Prepayment of outstanding loan amount ‘in-part’
- Prepayment in full
- Switching from floating rate to fixed rate
No levying of Penal Interest
If a borrower, does not comply with any of the loan terms and conditions, the lenders can only levy penalty for such non-compliance and cannot charge penal interest rate.
What is penal interest? – The penal interest is a type of penalty interest levied by the loan provider if a borrower does not pay the loan EMI as per the repayment schedule. If the EMI installments are not received as per the repayment terms, by the end of the month, the borrower will be charged interest on the installments delayed which is called as penal interest.
No Negative Amortization
As per these new instructions, the lenders should ensure that any elongation of tenor in the case of a floating rate loan does not result in negative amortization. Lenders will now be required to ensure that even in the event of significant rate hikes, the EMIs will continue to cover the monthly interest payments, preventing any increase in the outstanding loan balance from the previous month after the EMI is paid.
This means, the entire interest component for a month needs to be part of the EMI, and cannot be spilled in the next month, and added to the principal. This new rule can also lead to lower loan eligibility amount.
What is Negative amortization? – It means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.
Prepayment Penalty:
The Circular states that in case the borrower exercises the option to prepay the loan either in full or in part, the prepayment penalty or foreclosure charges shall be in accordance with the extant guidelines.
Quarterly Statement
To enhance transparency, the lending institutions need to send or make quarterly statements accessible with the below information for their borrowers;
- The total principal and interest recovered to date
- EMI amount
- The remaining EMIs
- The annualized rate of interest or Annual Percentage Rate (APR) for the entire loan duration.
Though the new rules on floating interest rate loans are commendable, the only major concern can be – the eligibility of some borrowers for loans may decline and banks / finance companies may be compelled to increase their margins on their loan books.
What are your views on these new floating rate reset guidelines? Can we expect more transparency from the lending institutions at the time of reset of interest rates?
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(Post first published on : 20-Aug-2023)
