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Your home loan rates will never be same again

Young Rashesh Dedhia bought his first home at 25 in January 2010. He was happy that a leading home loan provider offered him a loan of Rs 20 lakh at 9.25 per cent per annum on floating rate basis in December 2009. The lender told him his home loan interest will increase or decrease along with increase or decrease in general interest rates.

But sometime in June there began the talk that the banking regulator, the Reserve Bank of India, will direct all lenders to move to a 'Base Rate' system from July 1, from the current 'Benchmark Prime Lending Rate' (BPLR).

This confused Rashesh no end. He had heard about BPLR, teaser rate loans and now he had to contend with something exotic: base rate.

He was settling into a comfort zone by paying his monthly installments at the end of every month but he thought come July 1 his world will turn upside down.

The date came and went but Rashesh is still confused. To clear his doubts InvestmentYogi.com answers some commonly asked questions.

Impact of 'base rate'

The introduction of the 'base rate' system for lending has caused a lot of furore in our minds. As retail consumers we are puzzled with the impact this has in our lives. This article attempts to clarify a few frequently raised questions on this topic.

What was replaced and why?

The 'base rate' system replaced the erstwhile 'Benchmark Prime Lending Rate' (BPLR) which was introduced in 2003. However intense competition forced banks to lend a bulk of the loans at sub-BPLR (below BPLR) rate and it lost its relevance as a benchmark rate.

There were issues of transparency and a 'downward stickiness' to changes in the monetary policy. With a view to inculcate greater transparency in the lending system, the RBI introduced the 'base rate' system effective July 1, 2010.

What is the 'base rate'?

This rate is the minimum rate for lending to a bank's most credit worthy customer. The bank cannot lend below this rate (with an exception to DRI advances, loans to banks employees, loans to bank's depositors against their own deposits, albeit with the subvention of the central bank). For a retail customer, the base rate will cover all loans from auto loans, personal loans to home loans effective from July 1, 2010.

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How is the base rate computed?

The RBI has given the banks flexibility to decide on the computation of the base rate subject to its scrutiny. However the RBI circular on the base rate change has indicated the following as one method of calculation.

Base rate = Cost of funds (from deposits/liability sources and market borrowing) + unallocated overhead cost

The base rate covers the basic cost of financing the loan for the bank. It will not be financially viable for the bank to lend below the base rate.

The final rate of lending will be the base rate plus a spread. The spread includes borrower specific charges (product specific, operating costs, credit risk premium, tenor premium etc).

In short, the spread is mainly an indicator of the credit worthiness of the customer. For example, the final rate of lending for the home loan customer will be less than that for an auto loan customer or a personal loan customer due to the nature of the credit risk involved.

How often are the base rates likely to change?

The banks have been asked to review their base rate every quarter. Banks are required to exhibit the information on their base rate at all branches and also on their websites.

Click NEXT to read the impact for a fixed and floating rate customer.

What is the impact for a fixed and floating rate customer?

The base rate regime will have minimal impact on the fixed rate home loan customer apart from the fact that at the time of signing up for the loan s/he will know the bank's base rate and the associated spread. The greater transparency will help her/him in taking a more informed decision.

Otherwise, s/he will service her/his loan at the same rate of interest for the remaining tenor.

The impact of the base rate will be clearly understood by the floating rate customer. A revision in the interest rates (upward/downward) will impact the base rate, the spread remaining constant and the final lending rate to the consumer will change by the amount of increase/decrease in the base rate.

Say, for example, the interest rate was 10 per cent at the time of signing up for the loan (base rate: 8 per cent + other charges 2 per cent). Say the base rate changes by 50 basis points (100 basis points = 1 per cent) due to an upward swing in the deposit rates which means now the new interest rate will be 10.5 per cent for the customer (base rate 8.5 per cent + other charges 2 per cent).

A similar computation will take effect if the rates have a downward swing. This will address issues of 'downward stickiness' of rates in case of the BPLR regime.

Click NEXT to read the impact of base rate on existing and new borrowers.

How does it impact you as an existing borrower?

If you already have a loan which is based on the BPLR system there will be no change in the EMI payable. You can continue to service your loan till its maturity under the BPLR system. However if you wish, you can shift your existing loan to the new base rate system at no additional cost before the expiry of your loan.

If you are an existing borrower and wish to take any top-up loan then the new loan interest rate will be based on the new base rate system.

How does it benefit new loan customers?

The benefit is on account of greater transparency introduced into the system. You no longer will be flummoxed on the basis of the rate charged by the bank. You will now be equipped with information on the base rate of the bank and the spread charged (which will also depend on your creditworthiness).

The bigger benefit however is when there is a downward revision in interest rates, this benefit which had a certain degree of stickiness in the BPLR regime, will happen with a greater degree of transparency in the base rate structure.

While the base rate will have a very nominal difference across banks, the primary variable differentiating customers will be the spread which factors in the credit profile of the consumer. Therefore having a good credit profile will help you get better rates.

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What should you be doing?

While the actual change in the interest rate will be nominal if any, the new system ushers in greater transparency. This will also mean an end to the teaser home loan campaigns launched since banks can no longer lend below their base rate. Most banks have published their base rate in a public domain.

If you would have brought your home loan at a higher rate of interest and are still in the interest paying phase, you can re-negotiate your home loan with your bank and shift to the new base rate regime at no extra cost. For new buyers, this new transparency empowers you to take better informed decisions.

But please do note that these new guidelines are impacting only banks. Other NBFC lending institutions do not come under the purview of the base rate and can still lend basis the erstwhile BPLR system.