Experts believe that it is too early to predict the benefits of the proposed ‘transparent framework’ for modifying the EMIs of floating-interest-rate loans from the Reserve Bank of India. However, what industry observers are unanimous on is that this presents a good opportunity to introduce some much-needed transparency in lending practices.
As a part of the post-monetary policy committee meeting briefs, the Reserve Bank of India announced that it has decided to put in place a conduct framework to be implemented by all banks to address the issues faced by the borrowers.
“Whether such a framework will be effective or not we will get to know after looking at what the proposals being in the framework,” said Anil Gupta, an analyst from ICRA.
Atul Monga, CEO and Co-founder, of BASIC Home Loan — an online reseller agency— was of the opinion that the framework has the potential to “significantly benefit borrowers' by fostering a clearer understanding of loan repayment terms.
With this, he said, consumers can plan in advance their financial strategies to repay the borrowed amount.
“Transparent interest rate resets ensure that borrowers are informed about changes in their EMIs, promoting better financial planning and reducing the risk of payment shocks.”
FUTURE UNCLEAR
At present, borrowers of long-term loans, such as those used for financing home purchases, know how much they are borrowing, but not always how much they have to pay back.
This is because the amount that they have to pay back depends on the interest charged by the bank or lender, and this is almost never fixed in advance.
Instead, the overwhelming majority of long-term loans in India are sold as ‘floating rate’ loans, which means that the interest rate is tied to a benchmark, such as RBI’s own policy rates.
This means that what starts out as a 20-year-loan can end up as a 30-year-loan.
For example, a loan of Rs 40 lakhs at interest rate of 11% will take 13 years and 4 months to be paid off at an EMI of around Rs 47,750.
However, if the interest rate goes up by just 3 percentage points to 14% from 11%, the tenure of the loan will double to 27 years and 2 months.
“An increase in EMI tenure might create unwanted tension among the borrowers as they will have to plan a whole other strategy for loan repayment. These can be addressed with the RBI's proposed EMI resetting framework,” Vivek Rathi, Director- Research, Knight Frank India told NewIndianExpress.com.
The other option would be for the borrower to keep the tenure the same, and increase the EMI, which may turn out to be a better option for the customer. In the above case, for example, the customer can wrap up the loan in the same tenure by increasing his/her EMI by around Rs 8,000 per month.
“The lenders at the back end might keep the EMI the same by increasing the tenure of the EMI and the consumers absolutely have no knowledge about the changes. The consumers keep paying the monthly sum as EMI for a much longer term than they were aware of,” Gupta pointed out.
FORECLOSURE OPTION
He points out that RBI wants the lenders to not just communicate what changes they are making to their loans, but also guide them on how to keep either the EMI or the tenure the same.
The consumers not only have the option to change the tenure or EMI but they can also choose to foreclose the loan. Foreclosure is usually done when another lender offers to take over the existing loan at a lower interest rate.
Indeed, foreclosure is one of the options that the RBI wants the lenders to educate the consumers about when they reset the interest rates.
However, some banks might levy high foreclosure fees in the name of prepayment penalties when consumers opt to foreclose their loans. These fees serve as protection for lenders against losing their guaranteed interest income.
However, from the consumer's perspective, such penalties might nullify the option of foreclosing a loan and shifting it to another bank, unless the rate differential is very high.
Rathi, of Knight Frank, said that the Central Bank can work on pre-payment penalties to make the proposed framework more consumer-friendly.
"The bank has to be more dynamic allowing flexibility to consumers. Certain banks have unreasonable penalties. Better credit culture is good for the borrowers as well the lending institutions. Reducing the prepayment penalty will encourage borrowers to avail more loans, flourishing the banking sectors.”
FIXED-RATE OPTION
Another option RBI wants lenders to inform customers about is converting their borrowing into a fixed-interest rate loan.
Floating loan’s interest rates are tied to a benchmark — usually RBI’s own interest rates or the bank’s own ‘base rate’. Because of this, the interest rate applicable to the loan can keep changing, dragging with it the borrower’s liabilities.
Fixed interest rates, however, give the borrower the comfort of knowing the interest rate, exact EMI and the applicable tenure in advance.
"If one borrows a home loan with an initial tenure of 20 years. There is a huge risk involved in terms of an increase in EMI in terms of floating rate. These risks must be well communicated prior to the borrowers," Gupta pointed out.
He, however, adds that it is usually advisable to go for such fixed interest rate loans when the prevalent interest rate is low, and now may not be a very good time to make the switch because of prevalent high-interest rates.
“But, in the future, when the interest rates come down, the borrower can opt for a fixed rate,” he said.
Another problem is availability. Banks are not usually keen on offering fixed rate loans, and often charge a premium for such.
This is because they raise their funds for comparatively shorter periods, such as one year or two years, for a given interest rate. As a result, they cannot predict how much interest they themselves will have to pay to generate their funds after 2-5 years.
They cannot predict their ‘cost of funds’ in the long term. “Because of this, banks do not want to lock themselves into a fixed rate for a very long duration loan such as a home loan,” Gupta pointed out.
IMPACT ON BANKS
Meanwhile, consumers are not the only ones that will be impacted by the new framework. Monga of BASIC Home Loan pointed out that banks too will have their own challenges in implementing such changes: "Financial institutions might need to adapt their systems and communication strategies to accommodate this increased transparency effectively.”
One of the ways in which the new framework could impact the banks is by restricting their freedom to decide the pace at which they wish to transmit the changes, pointed out Vivek Rathi of Knight Frank.
“Different banks have different approaches towards transmitting repo rates to their consumers. While the RBI has changed its repo rate by 250 basis points recently, many banks have transmitted only 170-180 basis points to their borrowers. Banks follow different time frames and intensities impacting the loan tenures,” said Rathi.
This may be difficult in the future if RBI lays a timeframe for all the banks to transmit the changes as part of the framework.