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From Oct, loans to be linked to external benchmarks. How will this impact borrowers?

Loans linked to external benchmarks are going to be the norm from October 1.

, ET Bureau|
Updated: Sep 16, 2019, 10.26 AM IST
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Repo-linked loans from SBI will be reset on a monthly basis.
Major structural changes are afoot in the banking system. From 1 October, banks will move from the marginal cost of funds based lending rate (MCLR) regime to external benchmarking. What does it mean for you?

Let us first understand the basics of the change. From October 1, banks will offer external benchmark-linked loans and not just repo-linked loans. Public sector banks are aggressively peddling products linked to repo rates.

While most private banks are waiting for the 30 September deadline, Citibank has already adopted external benchmarking, linking its loan products to the three-month treasury bill. “Though several benchmarks are available, most banks are opting for the repo rate. This is because repo is more stable compared to other benchmark rates, which change daily,” says Harjeet Toor, Head, Retail, Inclusion and Rural Business, RBL Bank.

Second, these changes are only for floating rate loans and not fixed rate loans. So while home loans, working capital loans, etc will shift to the new regime, rates of auto loans, personal loans, etc will remain unchanged.

Third, the new regime will only apply to banks and not NBFCs. Leading housing finance companies like HDFC will not be under the purview of the new regime. However, if repo-linked rates of other lenders come down, competition will force NBFCs to match the rates. Finally, the rate change will apply to only new loans and all existing loans will continue as it is.

1. Don’t expect big fall in rates
Will this regime change result in a steep fall in borrowing costs? Unlikely. Banks are adding big “spreads” to cover operating costs and risk premium. For example, the lowest repo-linked rate for home loans from SBI is 8.05%, compared to 8.25% under the MCLR regime. While new floating rate loans will be linked to external benchmarks, most of bank’s deposits are still under the fixed rate regime and this will increase their asset-liability mismatch (ALM). “Since retail depositors are not very keen on external benchmark-linked deposits, banks will have a high ALM risk and this may get passed on as higher spread to the borrowers,” says Toor.

2. Lower interest in short term
In addition to a small gap (20 bps as per the SBI example given above), repo-linked rates may fall further in the short-term because RBI is expected to bring repo rates down to around 5%. However, repo rates are close to 15-year lows and therefore, chances of it going below 5% are remote. This can be a double-edged sword. Loan rates can zoom once the reverse journey starts (see chart) or if RBI suddenly decides to hike rates as it did in 2010.

Repo rate close to 15-year low
Your home loan EMI could zoom if RBI decides to hike rates as in 2010.
9-1
Note: Historical hypothetical home loan rate is based on the 2.65% spread taken by SBI.

3. Increased transparency
However, this move will increase transparency. “There will be a significant improvement in clarity. Now every borrower will know what his or her loan rate will be and why it is moving up or down,” says Raj Khosla, Founder & MD, MyMoneyMantra.

4. Faster reset
Another advantage of the new regime is the faster reset clause. RBI has asked banks to do it within three months. Repo-linked loans from SBI will be reset on a monthly basis. Any change in repo rates will be transmitted on the first day of the following month.

What about existing loans?

Since this regime change won’t impact existing loans automatically, borrowers have to visit the bank branch and request a change. New regulations allow banks to levy reasonable administrative charges while shifting customers from the previous regime to the new regime, so be ready to pay some money for this. If your bank is keeping a high spread on repo-linked loans, you should also be ready to shift to a new bank that offers a lower spread. How should you decide whether to shift or not? “The shifting process involves additional work. It doesn’t make sense if the gap is less than 50 bps,” says Khosla.

Though banks are keeping higher margins now for repo-linked loans, the same may come down in future due to increased competition. However, banks will try to protect their margin by cutting rates on fixed deposits and recurring deposits. “The interest rates are coming down in the system, so rates of fixed and recurring deposits will come down further. It makes sense for people with money to lock into current FD/RD rates,” says Toor. However, this fall will be shortlived and therefore, it doesn’t make sense to lock-in for the very long term. “After the current phase of rate fall, it may start going up. So don’t lock-in for long duration like 7 or 10 years,” says Khosla.

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