If the RBI raises interest rates, your home loan rate goes up. But when RBI cuts rates, your rates don’t go down. Why?
Whenever RBI announces an increase in its monetary policy rates, housing loan-providers, such as banks and finance companies, are quick to hike interest rates. However, the same efficiency is never shown by these lenders, when there is a rate cut by RBI.
It may sound unethical to borrowers, but lenders like to earn more and make more profit. The question, however, is: Why do regulators turn a blind eye to this unethical practice of lenders?
First, we need to understand that there are two types of lenders who provide home loans. One, banks that are regulated by RBI and finance companies, like HDFC and LIC Housing Finance, are governed by National Housing Bank (NHB). Banks and housing finance companies offer two types of interest rates on home loans, fixed and floating.
For a fixed rate loan, the interest rate is fixed either for the entire tenure of the loan or a certain part of the tenure. If it is fixed for certain part of the loan tenure, the borrower needs to read and understand the reset clause.
Floating rate loan changes with changes in market interest rates. When the market rate goes up, the equated monthly instalments (EMIs) also increase, and vice versa. However, borrowers often find that, despite the fall in market rates, their EMI has remained static.
The floating interest rate is made up of two parts, the index and the spread. The index is a measure of interest rates generally (based on, say, government securities’ prices or benchmark prime lending rates (BPLR). The spread is an extra amount that the lender adds to cover credit risk and profit mark-up. The amount of the spread may differ from one lender to another, but it is usually constant over the tenure of the loan. If the index rate moves up, so does the interest rate, in most circumstances, and the borrower will have to pay a higher EMI. Conversely, if the interest rate moves down, the EMI amount should be lower. Often, despite a rate hike, lenders keep the EMI constant, but increase the repayment period. But the borrower needs to check this with the individual lender.
In January 2015, RBI, for the first time since May 2013, reduced the repo rate by 25 basis points to 7.75%. The central bank had kept the benchmark interest rate at 8% since January 2014. However, despite huge expectations from borrowers, there was hardly any change in interest charged by lenders.
This happens because RBI has given banks freedom to set their interest rates. RBI, in its master circular issued on 1 July 2014, has said, “Banks may, with the approval of their Boards, determine the rate of interest, keeping in view the size of accommodation, degree of risk and other relevant considerations.”
Recently, RBI has allowed banks to relook at their base rate computation formula after three years instead of five years. The last time banks decided on the base rate formula was in 2010 and the asset liability committee (ALCO) of each bank is expected to take a call on this.
However, bankers still cite the higher average cost of funds, or incremental cost of funds, for not reducing the home loan interest rates, despite RBI reduction. When there is a rate cut in monetary policy, lenders first reduce their interest rates on deposits and, only when their average cost of funding comes down, they reduce their base rate. Another reason for lenders not reducing their base rate is that such action affects a major chunk of their loan portfolio and, thus, their balance sheet (read profit). Most banks use the average cost of funds for the previous quarter, to decide their benchmark rates.