U nder the Repo rate Linked Lending Rate (RLLR) regime, one can be sure of greater transparency in fixing interest rate on home loans, and change in interest rate.
Right from the introduction of housing finance system in our country four decades ago, one of the major grouses of existing home loan borrowers is that while they are forced to pay higher rate of interest, banks and Home Finance Companies (HFCs) offer lower interest rates to attract new borrowers. They are disillusioned to note that after establishing their impeccable track record of regular repayments and being loyal to the lender, when morally they should be rewarded with lesser interest rate than new borrowers, it is the other way round. Existing borrowers’ pleas to reduce interest rate on their loans are not heard either by lenders or by regulatory authorities.
Until the dawn of 21st century, the portfolio of home loans in the overall debt portfolio was negligible and as such a fixed rate of interest, which was in practice, was a feasible option. The setting up of National Housing Bank (NHB) in 1988, followed by establishment of specialised Housing Finance Companies (HFCs) and thrust given by foreign banks and new generation private sector banks to increasing home loan lending, resulted in quantum jump in outstanding debt of long-term loans. Since the risk of interest rate movement has to be borne by the lender in case of fixed rate loans, it became necessary for banks/HFCs to shift to variable interest rate schemes.
Since risk of interest rate movement was transferred to the borrowers, banks and HFCs could reduce interest rates by 2-3% as compared to fixed rate loans. Very soon variable rate home loans became popular and as of now, more than 95% outstanding loans are under variable rates.
Discriminatory methods
In a bid to improve their bottomline, banks and HFCs started using discriminatory methods to calculate interest rates for variable rate home loans. The interest rates were increased instantly when interest rates went up in the economy and seldom interest rates were reduced when interest rates came down. To attract new customers, banks and HFCs offered lesser interest rates and compelled existing borrowers to pay higher interest.
Regulatory authorities such as Reserve Bank of India and National Housing Bank started getting innumerable complaints from borrowers on the injustice meted out to them by banks and HFCs. The borrowers wanted the regulators to advice lenders to make transparent methods of fixing interest rates. The regulators had to intervene and issue guidelines to banks and HFCs on proper methods of calculating interest rates. First it was PLR (Prime Lending Rate) method during 2001-2010 and later Base Rate method from 2010 to 2016. Then came the MCLR (Marginal Cost Lending Rate) regime under guidelines issued by the RBI, which was introduced from April 1, 2016, and is still in vogue.
Although there was some improvement in transparency in fixing interest rates, the objective of safeguarding borrowers’ rights and total transparency could not be achieved.
According to the guidelines, the marginal cost should be calculated on the interest rate given for various types of deposits, namely savings, current, term deposit, foreign currency deposit etc., borrowings, like short-term interest rate or the Repo rate (the rate at which the RBI lends money to commercial banks in the event of any shortfall of funds), long-term rupee borrowing rate and return on net-worth (as per capital adequacy norms).
Transparency
For transparency, RBI has stipulated that the cost of borrowings shall have a weightage of 92% of cost of marginal funds and return on net-worth will have the weightage of 8% only. That means, the MCLR will be determined largely by the marginal cost for funds and by the Repo rate. Any change in Repo rate will effect changes in marginal cost, compelling automatic change in MCLR.
The actual lending rates will be fixed by adding the margins to the MCLR, depending on the risk factors such as secured, unsecured, short term, long term, and borrower’s credit worthiness amongst other things.
Although the MCLR method brought better transparency in fixing interest rates on loans and effecting change in interest rates, it did not achieve the critical aim of bringing full transparency in charging interest rates, as it was still linked to the internal benchmark of the lending bank.
The long pending demand of linking interest rate on home loans to an external benchmark, which is the normal practice in advanced economies, has been finally being accepted in our country also. The Reserve Bank has been suggesting banks to peg their lending rates to external benchmarks such as Repo rate or Treasury Bills.
Repo rate is the rate at which the central bank lends money to commercial banks in the event of any shortfall of funds. The Repo is used by monetary authorities to control cash flow in the economy and to control inflation. It is reviewed periodically, once in a quarter and altered considering various relevant factors.
When there is a cut in the Repo rate, the banks get money at a cheaper rate and if the rate is increased the cost of funds goes up. The Repo rate reflects the true interest rate movement in the economy and is decided by the Central government. If lending rates, especially long-term home loans, are linked to the Repo rate, it can bring in more transparency in fixing interest rates and for proper transmission of increased or decreased interest rate to the beneficiaries.
(The author is Managing Director of PropSeva Bangalore, and can be contacted at deshpande@propseva.com)
