Explainer: What the reset in interest rate norms means for borrowers
The Reserve Bank of India has proposed a common framework for determining interest rates to ensure consistency in the way lenders determine loan rates and spreads. It has also revised the norms for interest rates on bank deposits. Saikat Neogi explains how the changes will help borrowers as well as depositors
Why is RBI changing the loan pricing norms?
The draft guidelines seek to harmonise loan pricing regulations across all regulated entities into a single, unified set of directions. The guidelines will require lenders to set up a transparent structure that includes benchmark selection, interest computation, spreads and customer disclosures.
Borrowers often find it difficult to evaluate a loan product because of different bench-mark rates, varying spreads and inconsistent disclosures. A standardised framework, which is proposed to take effect from April 1, will bring in greater transparency in loan pricing, easier comparison across lenders and improve confidence of borrowers.
To improve transmission for floating rate loans, the benchmark reset frequency is now three months. While commercial banks will have to price all floating-rate personal and MSME loans to an external benchmark such as a repo rate, it will not be mandatory for non-banking financial companies (NBFC) or housing finance companies (HFC).
All existing loans and advances linked to any internal or external benchmark will migrate to the new framework by April 2029 without any hike in borrower interest rates.
How will interest rates on loans be determined?
Both fixed and floating rate loans will have to be linked to an internal or external benchmark plus a spread. Interest will be charged on monthly rests, except for agriculture loans, and calculated on a daily reducing balance.
This will standardise the methodology of interest rate computation across all lenders and eliminate the variation arising from different day-count computations. In case of floating-rate loans, lenders will have to reset at least once within three months, which will enable faster transmission of both rate cuts and rate hikes.
The draft guidelines have removed the ambiguity for hybrid-rate products by clarifying that fixed- rate provisions will apply during the fixed period and the floating-rate provisions during the floating period. For small value microfinance loans and personal loans up to Rs 50,000, the lender will explicitly cap the annual percentage rate inclusive of interest rate and other charges.
Will comparing loans be easier?
Yes, borrowers would have clearer information on the benchmark, spread and reset terms that determine a floating-rate loan’s interest rate. This could provide a more consistent basis for comparing loan offers, although the actual rates offered would continue to differ across lenders.
Loans cannot be priced below the benchmark rates, a floor-pricing rule that will apply uniformly. So, this will prevent NBFCs and HFCs from offering below-benchmark teaser rate or loans at a discount to the prime lending rate that undercuts the very benchmark meant to reflect the cost of funds.
Adhil Shetty, chief executive officer, BankBazaar.com says the proposed framework does not prescribe identical rates or spreads across lenders, so it would not make loan pricing uniform. “It does, however, require greater consistency in how lenders determine and disclose loan rates and spreads,” he says.
Can a lender still alter the spread?
No, it cannot alter the spread, which is the margin on the repo rate to calculate the final lending rate. The lenders will have to explicitly mention the spread components, including the credit risk premium, operating cost, term premium and business strategy premium.
The credit risk premium, which cannot be zero, may only be revised if there is a change in the borrower’s credit profile. The other spread components cannot be increased for floating-rate loans before three years from the first disbursement or the last revision.
This effectively curtails banks’ ability to increase spreads on existing floating-rate borrowers, a practice often seen when the benchmark falls. However, banks may front-load risk pricing at origination and borrowers will have to pay for that certainty. Lenders will have the flexibility to reduce the spread to retain the existing borrower only on a non-discriminatory basis.
How will RBI’s deposit framework impact savers?
In a separate circular, the central bank has revised the deposit-rate framework which will make the pricing process more consistent and transparent for retail savers. Effective from October 1, fixed deposits rates will be standardised across all branches and customers.
While retail deposit rates will continue to be disclosed in advance, bulk deposits rates —single rupee term deposits of Rs 3 crore and above — will have to be disclosed on the bank’s website by 10 am every business day, with a grace period up to 10.10 am. Companies can refer to the bank’s publicly disclosed bulk deposit rates instead of depending on the branch personnel.
Banks will have greater flexibility to price bulk deposits based on liquidity standards. For existing depositors, the framework doesn’t mean that banks will suddenly change their contracted interest rate from October 1. Moreover, banks will continue to price deposits based on their own cost of funds, liquidity requirements, and prevailing repo rate cycles.