Home loan: era to move to base rate

The interest rates in the country have started firming up with an uptrend in the growth rate of the economy. Even the Reserve Bank of India (RBI) is increasing the policy rates, which would lead to a rise in the interest rates, to contain the rising inflation in the country.

On July 2, in order to contain the price rise, the RBI increased its repo rate – the rate at which it lends short-term funds to banks – by a quarter of a percentage point to 5.50 percent, amidst prevailing tight liquidity conditions in the banking sector. This is likely to push up the interest rates on all loans including home and car loans.

Interest rates may push up

Economists and bankers feel that as the inflation continues to rise, the RBI may tighten the rates further on July 27, when it will review its credit policy. This may force banks to revise their interest rates upwards. However, this will not immediately affect existing customers, even if they have borrowed their home loan at the floating rate of interest, provided they have shifted the benchmarks to fix their home loan rates to base rates.

According to the RBI guidelines, all banks announced their respective fixed rates from July 1, 2010, which will act as their benchmark rates for their future loans including home loans given at variable rates of interest. However, for existing customers who have borrowed prior to July 1, 2010, the earlier benchmark – prime lending rate (PLR) – will remain operational.

Interest rates on home loans will remain unchanged

As the base rates are fixed for three months and can now be changed only after September 30, the interest rates on home loan and other variable interest rate loans will remain unchanged till then. But, the earlier benchmark rates like PLRs can be changed anytime, when the interest rates in the markets firm up.

Banks have given their existing customers the options to shift their benchmark rate to the base rate from the existing system of benchmarking against the PLRs. One bank, in its website, has said there is a provision for an existing customer to migrate to the ‘base rate’ based interest rate. “There will be no fee or charges for this migration,” says the bank. Interestingly, the benchmark migration to the base rate will not result in any change in existing effective interest rate for the customer. While the existing benchmark rate will be replaced with the base rate, the bank says, the margin would be adjusted accordingly to maintain the effective current interest rate.

Base rates vs interest rates

Assume you have a home loan of Rs 20 lakhs and the current effective rate of interest of 12 percent, now, with migration to base rate as the benchmark, your rate of interest will continue to be 12 percent (7.5 percent the base rate plus 4.5 percent margin). The bank has fixed its base rate at 7.5 percent.

However, if the interest rates firm up because of an increase in the policy rates by the RBI, banks are likely to increase the margin over and above their respective base rates to charge increased lending rates from new customers.

But, as the banks are supposed to visit their base rates every three months, they will have to cut their base rates if interest rates in the market fall. The base rate is fixed on the basis of various costs that a bank incurs in mobilising funds and is a more transparent system. In the earlier system of benchmarking the rates against PLR, banks used to raise the PLR if the interest rates in the system firmed up. But, when the rates fell they seldom cut their PLRs. If they did not cut the PLR, the existing borrowers continued to pay high interest rates. But, to lure new borrowers, they passed on the benefits of the lower interest rates by increasing the discount on the PLR.

Borrowers will be benefited

But, in the new base rate system, the RBI has tried to address such discrepancy. If the interest rates fall, banks will have to lower the base rate, which is a function of cost of funds in the market. As all the variable rates of interest are pegged against the base rate, the existing borrowers will also be benefited by any cut in the base rate.

Therefore, it is advisable for the existing borrowers to opt for the base rate as their benchmark rate. They should approach their respective banks and request them to change their benchmark to the base rate from the existing PLR or floating rate of reference.

You might find these relevant:

Home loan: era to move to base rate

Leave a Reply