The Reserve Bank of India (RBI) is in the process of establishing a comprehensive framework to regulate the adjustment of interest rates for floating-interest loans. The proposed regulations will require lenders to maintain clear and transparent communication with borrowers regarding potential changes, such as extending the loan tenure, transitioning to fixed-rate loans, and more.
One common practice is when banks decide to elongate the repayment tenure of a loan instead of increasing the equated monthly instalments (EMIs) when interest rates rise. Although this approach might not immediately burden borrowers with higher EMIs, it eventually results in significantly higher total interest payments, particularly for new loans. As an example, the recent increase in the repo rate by 250 basis points from May 2022 to February 2023 has led to some borrowers’ repayment tenures extending beyond their retirement age.
For borrowers, this scenario could pose difficulties in servicing a loan during retirement. To mitigate such potential challenges, the RBI is advocating for mandatory borrower consent in cases where banks propose an extended tenure in lieu of higher EMIs. By doing so, borrowers can make informed decisions based on the trade-off between a higher monthly EMI and a prolonged loan tenure. The RBI’s stance is that while banks can have a say in this matter, they must take into consideration factors like the borrower’s age and repayment capacity when making such adjustments.
The initiative also stems from the need to expedite the transmission of interest rate changes to borrowers. To address this, the RBI introduced the external benchmark-based lending rate regime in October 2019. This was done to improve the transmission mechanism, as the previous Marginal Cost of Funds based Lending Rate regime, introduced in April 2016, was deemed unsatisfactory in this regard.
External benchmark rate
Under the external benchmark-based lending rate system, banks determine their spread over the external benchmark rate for the loan’s duration, influenced by factors such as the borrower’s credit score. This approach aims to enhance transparency in retail loan pricing. Notably, the reset period for both the interest rate and the EMI is three months.
If a cap is imposed on the tenure, banks have two potential options to address the situation. They can either increase the EMI amount or request a partial payment from the borrower, which would maintain the EMI at the same level.
In the event of rising interest rates, home loan borrowers are advised to consider pre-payment in addition to regular EMIs. This strategy reduces the outstanding loan tenure and the overall interest burden. Pre-payment can be done incrementally without jeopardising the borrower’s existing financial goals. If additional funds are unavailable, increasing the EMI could be an alternative solution, helping to reduce the cumulative interest expense. Importantly, lenders generally do not impose pre-payment penalties on floating rate home loans, but prepayment interest may apply based on the principal outstanding and the pre-payment date.
