The story so far: On August 18, apex banking regulator the Reserve Bank of India (RBI) issued guidelines enabling a borrower to transition from a floating interest rate-based loan to one with a fixed interest rate.
According to RBI, the endeavour was to address borrowers’ grievances pertaining to elongation of loan tenure and/or increase in the EMI amount in the event of an increase in the benchmark interest rate. A lack of proper communication along with the absence of consent too formed part of the concerns.
The provisions would be extended to existing as well as new loans by the end of the current calendar year.
What exactly has the RBI instructed?
As stated above, the apex banking regulator has given borrowers the option to switch over to a fixed (interest) rate mechanism for their loans from floating rates. This would be based on a board-approved policy drafted by the lending entity. The policy must also specify the number of times such a switch would be allowing during the tenure.
The lender must also transparently communicate to the borrower all relevant charges alongside service charges or administrative costs associated with the transition.
The responsibility would rest with the lender to communicate clearly, at the time of loan sanction, the impact emanating from the change in regime (floating to fixed), such as the change in EMI and/or tenure of the loan or both. Additionally, the borrower would now also have the option to choose between enhancement of the EMI or elongation of the tenure or a combination of both. S/he might also opt to prepay the loan, either in part or full, at any point during the tenure. This would, however, still invite foreclosure charges or pre-payment penalty.
Further, the regulator has sought that lending entities provide borrowers, through appropriate channels, a statement at the end of each quarter enumerating the principal and interest recovered till date, EMI amount, number of EMIs left and annualised rate of interest/ Annual Percentage Rate (APR) — for the entire tenure of the loan. RBI has asked for the statement to be “simple and easily understood by the borrower”.
The instructions would apply to all equated instalment-based loans of different periodicities. albeit with certain changes based on the nature of the loan.
What is the difference between a fixed and floating interest rate?
Fixed interest rates are those that do not change during the tenure of the loan. On the other hand, floating interest rates are subject to market dynamics and the base rate — therefore, the risk differentiation. As also contended by several lending entities, floating interest rates are generally lower than the fixed interest rates. For example, if the floating interest rates for home loans is 10.5%, the fixed interest rate would be 12%.
Lenders argue that even if the floating interest rate were to rise by up to 2.5 percentage points, the borrower would be able to save more money when it is below the fixed rate. It has been widely argued that their preference for the floating rate-based regime is to better adjust their positions as per the evolving market dynamics. Should the benchmark rates drop significantly, the advantages are transmitted onto the borrower’s savings pool, but the opposite also holds true in a rising benchmark rate regime. Also noteworthy is the fact that floating interest rate loans do not draw any prepayment penalty— unlike fixed rate loans.
However, the fixed rate-based regime endows a borrower with greater certainty and security. This also helps in better planning and structuring of individual budgets.
Thus, prospective borrowers should note broader evolving economic dynamics and accordingly decide the tenure they seek.
In a largely similar context, in 2010, V.K. Sharma, then Executive Director at the RBI, said at a conclave that lenders may argue that housing loan borrowers would prefer a floating-rate loan to a fixed rate. This is where RBI’s guidelines relating to “customer appropriateness and financial literacy and credit counselling” enjoined upon banks come in, he pointed out.
“This is because typically an unsophisticated, and uninitiated, borrower may be driven largely by the prevailing lower short-term interest rates, almost completely oblivious to the potentially higher interest rates over such a long-time horizon, as say, 10 years or more,” he stated.
What does the regular state about assessment of repayment capacity?
RBI stated in the circular that lending entities are required to consider the repayment capacity of the prospective borrower. This is to allow borrowers adequate (or optimum) headroom/margin for elongation of tenure and/or increase in EMI.
About parameters for assessment, Governor Shaktikanta Das, too, had earlier stated that banks would have to consider the payment capacity of the borrower and how longpayment capacity would last (the age factor). He cautioned that it would be necessary to “avoid unduly long elongation which sometime may going forward camouflage the underlying stress in a particular loan.” The extension, he stated, must be for a “reasonable period”.
“It is a commercial decision that the banks have to take. We are just providing some broad guidelines,” he informed.