Home loan interest rates: What external benchmark means for your floating rate loan

Joydeep Sen

Let us see how the interest rate on your loan works. In a fixed rate loan, let’s say a fixed rate home loan, the rate of interest is fixed for the entire tenure, unless there is a clause in the fine print that allows the lender to change the interest rate even in a so-called fixed rate loan. If it is a fixed rate home loan in the true sense, the rate of interest will not change.

In a floating rate loan, the rate of interest is ‘floating’ because it is not fixed; it varies over the life of the loan. There is a benchmark, which is the reference point for determining the rate, and there is a spread, which is the additional component that you have to pay over the benchmark. For example, if the benchmark is the bank’s Marginal Cost of Funds-based Lending Rate (MCLR), then the MCLR plus spread is the rate of interest to be paid.

There will be a reset period e.g. if it is annual reset, the rate of interest will be reset with the benchmark every year. The benchmark rate itself is variable, which is why the rate is called floating.

In the latest monetary policy review of the RBI on December 5, 2018, along with the policy review document, the RBI released a statement on Developmental and Regulatory Policies (SDRP), which is a standard practice.

The SDRP stated that from April 1, 2019, new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks shall be benchmarked with reference to an external benchmark. Let’s understand what an internal benchmark is and what an external benchmark is.

Something which is determined by the bank or is influenced by the bank, e.g. Benchmark Prime Lending Rate (BPLR), or MCLR, is internal. Something over which the bank does not have any control or influence is external. The SDRP mentions the external benchmarks as:- Reserve Bank of India policy repo rate, or
– Government of India 91-days or 182-days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL), or

-Any other benchmark market interest rate produced by the FBIL

The SDRP also mentions that “The spread over the benchmark rate — to be decided wholly at banks’ discretion at the inception of the loan — should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract”.

What is the significance of this regulatory measure on floating rate loans? Sometimes, when interest rates in the economy are coming down or the RBI is giving a signal by reducing the repo rate, banks are slow in passing the benefit to existing customers.

On the other hand, when interest rate is rising, banks are fast to react. If the benchmark is external, the bank does not have any control or influence, and the reset of loan rates will be more equitable and fair. However, one important aspect to be noted by borrowers is that it is not a one way street. If you have a grievance against banks for improper passage of lower interest rates, when interest rates in the economy are rising, the external benchmark may rise faster than you estimate. When the loan rate reset happens at a rate higher than your expectation, you have nobody to blame because, in all fairness, the bank is following an external benchmark.

In this context, it is important for you to understand what these external benchmarks are and how these are set or determined by the market.

The policy repo rate is the rate at which the RBI would lend to banks for one day, and is the starting point or fulcrum for the entire interest rate structure of the economy. This rate is set by the RBI monetary policy committee after looking at multiple variables like inflation, growth rate of the economy, currency exchange rate, global interest rates, etc. When inflation is high, RBI increases the repo rate as they want to cool down the economy and vice versa.

The 91-day or 182-day Treasury Bills are traded in the secondary market, and the traded yield levels i.e. interest rates are collated and communicated by FBIL. The basic difference between internal and external benchmarks are the basis on which it moves.

Internal rates are set on an administrative basis, based on RBI repo rate signal, availability of funds with the bank and the projected demand for funds. In the secondary market, T-Bills trade on the basis of expected movement of inflation and interest rates, anticipated rate action from the RBI and liquidity in the system, apart from other factors.

Net-net, if you are considering a floating rate loan after April 2019 based on the proper passage of rate movement in the economy, it has to be borne in mind that a loan is for a long tenure and interest rate cycle can reverse over this period.