Volatility in interest rates in India

The volatility in interest rates in India has affected borrowers of all types of loans. However, home loan borrowers are the most affected, as home loans are by far the biggest loans quantum-wise. Discrepancy in interest rates between existing borrowers and new borrowers, porting of home loan, stringent rules by lenders and clauses on fixed rate home loans are some of the issues faced by home loan borrowers in the country.

Let's look at them in detail:

One of the most common issues faced by existing home loan borrowers is the discrepancy in interest rates paid by them vis-a-vis a new borrower. While this is a valid complaint, let's first see what causes this discrepancy.

Interest rates on home loans are usually linked to the benchmark rate of the bank (be it the Prime Lending Rate - PLR or the more recently introduced Base Rate, as the case may be).

From this benchmark rate, a fixed rate is either deducted (in the case of a PLR) or marked up (in the case of a Base Rate) to arrive at the floating rate on the home loan. Any changes in the benchmark rate will thus automatically result in a change in the interest rate on the home loan as well.

For example, consider a borrower who has taken a home loan from a Housing Finance Company (HFC) at terms which state that his interest rate will be 300 bps lower than the prevailing PLR. This was the agreement entered into with the bank at the time of availing the loan. The PLR at the time of granting the loan was 15 per cent, and the interest rate on the home loan thus stands at 12 per cent. Now, if after 2 years, the PLR is reduced by 50 bps to 14.5 per cent then the interest on his home loan also automatically falls to 11.5 per cent.

On the other hand, in order to attract customers, a new borrower may be offered terms with a mark down of 350 bps. As a result, the interest rate he gets on his home loan will be 11 per cent only. This is the reason for the discrepancy in interest rates.

In recent times, in view of the increasing incidence of customers switching banks to avail better rates, the existing borrowers are being offered an option to change to new rates in the same bank by paying a switch fee or a conversion fee. This can be 0.5 per cent to 1 pre cent of the outstanding loan amount. This is a good way of availing interest rates offered to new customers. However, this scheme is not actively pushed by banks, and not all lenders offer this.

In such a situation, most existing borrowers resort to porting their home loans to banks which offer lower interest rates. This has been encouraged by RBI by removing the prepayment penalties on floating rate loans.

However, it is important for customers to read the fine print before taking this step, as there may be many unanticipated costs to be borne. Processing fee, stamp duty, notarization charges, franking charges and insurance premium are some of the likely costs which a customer needs to bear.

This can easily work out to be 0.5-0.75 per cent of the loan amount. Add to this the requirement of submitting all documentation again to the new bank. It is therefore important to understand the merits of switching your home loan, and try to use the option of staying with your old bank using the switching fee option, wherever possible.

Another issue faced by fixed rate home loan borrowers in the applicability of the reset clause. Fixed rate loans are not fixed for the entire loan tenure. The reset clause is invoked as and when applicable according to the terms of the agreement. Thus, if there is a scenario of increasing interest rates in the economy, banks will reset the interest on the fixed rate home loan. Although there is no option to remove this clause, borrowers can search for banks that offer fixed rate loans with no reset clause.

Borrowers also sometimes face the issue of the inflexibility on the bank's part to adjust the EMI amount or tenure in case of an interest rate revision. The hassle of reworking EMIs as well as changing ECS mandates may deter banks from changing the EMI amount. However, from the customer point of view, it must always be remembered that reducing the tenure is a better option compared to reducing the EMI amount in case of a downward interest revision, to save on interest costs.

It is hoped that RBI and the government will continue to take proactive steps in addressing the concerns of home loan borrowers - both existing as well as new borrowers

Interest Rates for Premature withdrawal

Many of us invest in fixed deposits (FDs) as they are safest investment option available today. But most of the time while investing, we don't spend too much time on thinking where to park our FDs. However, the fact is we can save quite an amount if we carefully select our fixed deposit option.

In order to maximise returns, while it is useful to get high interest rates, it is also a good idea to minimise the cost of unplanned FD closure. Often, when we are need of funds, we tend towards breaking the fixed deposit. As a result we not only we lose on interest rates, but are also penalised as much as 1 per cent in the name of premature withdrawal penalty.

While this may seem a small number, it becomes sizeable when actual cost is calculated. Most banks calculate interest rates for premature closure of FDs by the following formula:

Interest Rates for Premature withdrawal of FDs = Interest Rate applicable for actual period of FD as per the rates prevalent at the time of investment - 1 per cent

Most of the banks charge premature withdrawal penalty as per the above formula for all fixed deposits, including linked FDs with sweep in facility and FDs with periodic interest payouts.

In case of FDs with periodic interest payouts, where banks have already paid the investor interest as per the committed rates, banks calculate the applicable penalty at the time of redemption, and reduce the final payout by the same effectively reducing the interest rate to the rate as per the above formula.

However, the premature withdrawal penalty can be completely avoided as several banks have started offering premature withdrawal without penalty. In fact, you will be surprised to know that some of them also offer the best interest rates on FD's. The following table lists interest rates offered on FDs and premature withdrawal penalties levied by major banks:

The above comparative shows that Axis Bank, Yes Bank and IDBI Bank offer high interest rates and also allow premature withdrawal without penalty.

On the other hand, major retail banks like ICICI Bank and HDFC Bank offer lower interest rates and charge hefty premature closure penalties.

Let us take an example where Ajay has invested Rs. 3 lakh each in Axis Bank and HDFC Bank for a period of 3 years but withdraws the money in 1 year. The following is the return Ajay gets from both FDs:

While both the FDs are offering same returns for 3 year period and the interest rate applicable for 1 year is also same in both the cases, Ajay loses out Rs. 3,479 only due to penalty in case of HDFC Bank.

One might think about the case where FD rates are lower for the actual deposit period than the original period; and the case where FD rates at the time of booking were higher than rates prevailing at the time of FD closure. In such cases, banks take the lower of the two rates to pay interest.

So, next time when you book your FD, do not forget to check the premature withdrawal penalty along with interest rates, else you may land up losing out on easy money

Home Loan Interest Rate Details

Buying home is a lengthy and tiring process especially when you avail home loan to buy it. Tenure of loan is normally in the range of 15 to 20 years and a fair share of anxiety is caused by changing interest rate scenario for floating rate loans during this period. Old customers frown when key policy rates go up and they frown again when it goes down. Read on to understand how housing loan interest rates are linked to key policy decisions like variation in repo rate and CRR together with its impact on old/new home loan borrowers.

How Home Loan Rates are Calculated?

RBI has defined guidelines based on which banks fix their base rate for lending. No bank is allowed to lend below the base rate and base rates differ slightly from bank to bank.

Once a customer approaches a bank for home loan, he is charged a premium over base rate. Premium charged may vary from customer to customer based on his creditworthiness and other factors. Hence, the exact home loan rate a customer will be charged is as follows:

Home Loan rate = Base Rate + Premium

(Premium varies from bank to bank and customer to customer)

Relationship between Policy Rates and Home Loan Rates

Base rate for banks is calculated based on cost of funds for them. Repo Rate and CRR bears direct relationship with the cost of funds. Repo rate is the rate at which RBI lends money to banks and CRR is cash which banks need to keep with RBI as a regulatory requirement. As repo rate increases, cost of funds increase for the banks and this puts upward pressure on base rate. RBI pays no interest on CRR amount hence, when CRR goes up cost of funds increases for the banks. Similarly, situation reverses when there is repo rate and CRR cut.

Correlation between the repo rate and CRR with base rate is direct as they move in the same direction, but the correlation is weak for repo rate and strong for CRR.

Key Observations – How banks behave in case of variation in repo and CRR

It’s easy for banks to lower the base rate in case of CRR cut and pass on the benefit to its customers as compared to repo rate cuts. Same is visible in their action. They respond slowly to repo cuts and hesitate in passing the benefits to customers while CRR cut affects base rate quickly. Banks act more swiftly when policy rates are increased. Increase in repo rate or CRR immediately impacts the base rate resulting in a proportional increase. As a borrower few important points to note here are:

1. Banks push base rate up immediately once RBI increases the repo rate and CRR
2. Most banks hesitate to reduce the base rate in case of repo rate and CRR cut by RBI
3. Private banks in general are more responsive to policy rate variations by RBI

Effect of policy rate cuts – Existing customer vs. new customer

One should not forget that banks are business houses and they will always try to increase their profit margin. This is the reason why they respond slowly while policy rate cuts are announced and swiftly when rates are revised upwards.

Changes in key policy rates affect the existing and new loan customer in the following way:

Existing Home Loan Customers – If you are an existing customer you will always be at the receiving end. Base rate will swiftly increase in case of increase in policy rates resulting in increase in EMI or increase in tenure of your loan. Contrary to this, when policy rates will be cut, bank would hesitate in passing on the benefit to you by reducing the base rate. If the bank is too hesitant in passing the benefit, you can opt for loan transfer and choose a more ethical vendor.

New Home Loan Borrowers – To acquire new borrowers, banks play with the premium they charge over base rate rather than the base rate itself in case of policy rate cuts. They reduce premium to lure new customers and make it sound like passing benefit to the customers. This is the reason new customer gets loan at lower rate compared to the existing one in falling interest rate scenario. If you are planning for a home loan, just wait for the right moment as you can negotiate better rates.

Conclusion

Banks and home finance companies will always try to protect their profit margins, hence you should not expect too much from them. But if you feel that you are getting a raw deal every time, you can look for a loan transfer facility. Talk to an advisor for getting more clarity on the transaction cost involved in the loan transfer process and opt for it if benefits exceed the cost.