6 min read.Updated: 19 Nov 2019, 09:51 AM ISTRenu Yadav
Some of the external benchmarks that banks are allowed to use are more volatile
More volatility in external benchmark rates would mean your home loan EMIs will change more frequently
If you have shortlisted your dream home and are looking for a home loan from a bank, you will find plenty of options. But it makes sense to do some research before picking one as a home loan is a long-term commitment and, typically, involves a huge sum of money. Moreover, now that the Reserve Bank of India (RBI) has asked banks to link all floating rate retail loans, including home loans, to an external benchmark from 1 October, your research needs to be sharper as it’s something new. Here are four things to check under the new regime.
RBI has identified a list of external benchmarks—three- or six-month Treasury bills (T-bills), repo rate or any other benchmark rates declared by Financial Benchmarks India Pvt. Ltd—to which banks can link their loans to. Most banks are using the repo rate as their benchmark, while Citibank has pegged its lending rate to three-month T-bills.
You need to look at the benchmark a bank uses because some of them could be more volatile than others. More volatility in rates would mean your equated monthly instalments (EMIs) will change frequently. “Benchmarks such as T-bills tend to be more volatile and are generally suited for customer in the higher income bracket as they may be okay with slightly higher changes in EMIs and are certainly not suitable for lower- and middle-income borrowers," said Gaurav Gupta, founder and CEO, MyLoanCare, an online loan aggregator.
It may be noted here that you can expect more transparency and better transmission of rates with the introduction of external benchmarks. Earlier, banks often did not pass the benefit of RBI rate cuts to existing home loan borrowers though they were quick to cut deposit rates. Even if banks cut lending rates, they did it only for new customers, and existing customers got the benefit only after a time lag. At the same time, any rate hike by RBI would see faster transmission in loan rates but not in deposit rates. “Under the new regime, the transmission of changes in the benchmark rate will happen automatically for both existing as well as new customers," said Raj Khosla, founder and managing director of MyMoneyMantra.com, financial service provider.
The reset period
Every home loan comes with a reset date, and any new rate comes into effect from this date. RBI has asked banks to reset their rates at least once in three months, unlike under MCLR (marginal cost of lending rate), the earlier internal benchmark that banks were mandated to use, where the reset, typically, happened once a year.
While most of the banks have adopted a reset period of three months, some banks, including Bank of India (BoI), have fixed a monthly reset. However, since the bank has pegged its rate to the repo rate, which is generally revised on a quarterly basis, its home loan rate will effectively change in three months only.
Some banks have clearly stated the dates on which the reset will happen. For example, Citibank, which uses three-month T-bills as its benchmark, has stated that it will review and publish the T-bill rates on a monthly basis, but the reset will happen only on a quarterly basis and on the first date of every calender quarter. So the reset dates are 1 March, 1 September, 1 June and 1 December. So if the benchmark rate is cut in October and November by 10 basis points each (one basis point is one-hundredth of a percentage point), then the lending rate will go down by 20 bps on 1 December.
It’s best for you to get clarity on the reset dates at the time of borrowing to ensure you are able to manage your finances better. “Read the fine print and take time to understand it. Don’t sign anything unless you are sure you are clear about what you are committing to," said Navin Chandani, chief business officer, BankBazaar, a financial services platform.
The spread is basically what a bank charges over and above the benchmark rate. Your lending rate is essentially the benchmark rate plus the spread. Banks are free to decide the spread they want to charge from a particular borrower at the inception of the loan.
To ensure you get the cheapest deal, compare the total spread being charged by different banks using the same benchmark. Even at any time during the tenure of the loan, you can compare the spread being charged by your bank with what other banks are charging.
“Spread is an indicator of the risk and profit margin as assessed by the lender. So, choosing a lower spread means locking into a lower rate and, hence, it’s important," said Mishra.
Credit score weight
The overall spread being charged by a bank above the benchmark rate will include the operating cost as well as the credit risk premium, among other costs. As per RBI guidelines, banks can change the spread if there is a change in the operating cost, but only once in three years. However, the spread or credit risk premium can also be changed if there is a substantial change in the credit profile of the borrower.
Some banks have linked the risk premium to three-digit TransUnion Cibil score (which ranges between 300 and 900 and is based on previous credit repayment history), while some use internal parameters and classify borrowers in different risk categories and charge a spread or risk premium accordingly. For example, BoI will charge a premium of 10 bps from a borrower whose Cibil score is 760 or above; 30 bps if the Cibil score is between 7 25 and 759, and 40 bps if the Cibil score is between 724 and 625.
“Credit score has always been important. This policy announcement has just underscored the existing rules. In cases of a bounced EMI or deterioration in the credit score, the lender can increase the spread on the loan," said Aditya Mishra, CEO, SwithMe.in, a Mumbai-based loan aggregator that specializes in home loans.
“Under the new regime, the spread is determined by a combination of fixed spread and credit risk premium. Credit risk premium may undergo a change based on the borrower’s risk profile over time. Borrowers should look at both before choosing their best option," said Shantanu Sengupta, managing director and head, consumer banking group, DBS Bank India.
A falling interest rate scenario would definitely work well for you, but the reverse may come to pinch you, especially if the option to increase the tenure does not exist. In any case, increasing the tenure ultimately leads to additional cost and is, hence, not advisable.
You would now need to be more diligent about planning your finances. “Even though the increase in rate results in a small increase in EMI, it pays to plan for it in advance. Just calculate the EMI at a higher rate and plan to have the means to bear it. Tenure increases the cost and should be used only if bearing higher EMI is difficult. Conversely, in a falling rate scenario, customers should save to create a repayment pool instead of spending the money," said Mishra.
The external benchmark is certainly a more transparent mechanism, but remember to look at other factors such as the quality of services provided by the bank, the processing charges and so on.