Recently, the banking ombudsman in Delhi ruled in favour of two home loan borrowers against a bank. Both claimed that they had not received the benefit of a floating rate loan they had taken and had been paying high interest rates even when new borrowers were being charged less. Also, when they wanted to prepay their loans, the bank did not allow them to do so without a prepayment penalty. The ombudsman has directed the bank to waive the penalty if they choose to prepay their loans or give them the benefit of a lower interest rate being offered to new borrowers.
Many more cases related to alleged unfair trade practices adopted by banks in the mortgage market have been pending before banking ombudsmen across the country. Even the Competition Commission of India is looking closely at this issue. The objective of the commission is to promote competition in markets; prevent practices that have adverse effect on competition; and protect the interests of consumers. The commission feels that there is cartelization among banks to deny benefits to home loan customers. Banks, on their part, are strongly defending their stance. The two customer complaints in Delhi against one particular bank have the potential to snowball into a major issue for the Indian mortgage market, involving millions of consumers.
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There is no clarity on the exact size of the market as banks do not give the home loan disbursement figures separately in their balance sheets. They are clubbed with other retail loans. According to sector analysts, Housing Development and Finance Corp. Ltd (HDFC), India’s oldest mortgage lender, roughly accounts for 30% of the market. If that’s indeed true, the market will grow by about Rs 1.4 trillion this year and add at least 600,000 customers as HDFC’s retail home loan book is expected to grow by Rs 42,000 crore in fiscal 2010, disbursed among 185,000 consumers.
HDFC, State Bank of India, ICICI Bank Ltd, LIC Housing Finance Ltd and Axis Bank Ltd account for about 80% of the market that has been growing at a compound annual growth rate of 25% in past five years. India has a housing shortage of 24.7 million units and at about 7% of the country’s gross domestic product, the mortgage market will continue to grow at a scorching pace for many years.
There are two types of home loans—fixed- and floating-rate loans. Typically, the fixed-rate loans cost much higher than the floating-rate loans and the difference between the two could be as much as 4 percentage points. This is because the average tenure of a home loan is about 15 years and as banks do not have long-term resources, they are taking an interest rate risk while lending long. A floating rate loan, in contrast, costs less as here the price of the loan is theoretically linked to a benchmark rate, which changes in accordance with the cost of borrowing. So, when the benchmark rate goes down, the cost of a floating-rate home loan should decline and vice versa. Big-ticket home loan borrowers often split their loans into two and borrow both at fixed and floating rates to hedge against interest rate risk.
A borrower takes a fixed-rate loan when she feels that interest rates will go up. By locking herself into a fixed-rate loan, she insulates herself from interest rate risk. In case the interest rate declines, she loses the benefit and may like to prepay the loan. In this case, banks are justified to impose a prepayment penalty.
But why would a floating-rate customer want to prepay her loan? After all, isn’t the loan rate linked to a benchmark rate that changes when the market rates change? Theoretically she can never be a loser, but the reality is different. Many floating rate customers, too, want to prepay their loans because they are not getting the benefit when banks lower their home loan rates. This is because Indian banks and housing finance firm are offering lower interest rates to new home loan seekers under various schemes without changing the benchmark rate.
Unlike in developed markets, where floating-rate loans are linked to the London inter-bank offered rate, or Libor, in India there is no external benchmark for interest rates. Banks have their own benchmark rates that are often opaque. They are always fast to act when rates go up and slow in passing the benefit to their customers when the rates go down. This is an old practice.
What is hurting the consumer more is the industry’s innovation of various schemes to offer low interest rates to attract new home buyers. Often consumer appliances makers create such schemes to clear their inventories of microwaves, television sets and refrigerators, but buyers of white goods make one-time payments while home loans are serviced over many years. New home loans are not inventory clearance and banks can only give them at cheap rates if their cost of funds justifies it. In that case, why shouldn’t the existing borrowers, too, get the benefit of lower borrowing costs? If they are denied such benefits they should at least be allowed to prepay their loans without any penalty as this will enable an existing customer of one bank to refinance the loan by taking a fresh loan from another bank at a cheaper rate.
If banks don’t want to do this, citing the cost of funds, the model is terribly faulty. Discrimination against one set of borrowers is only one side of the story. Banks are running huge risks by offering home loans at a rate cheaper than inflation. Aggression to garner market share is fine as long as it doesn’t affect asset-liability management.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to firstname.lastname@example.org