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Floating rate home loans

Five things you must check about floating rate home loans
 
“What goes up, comes down!” – this is the universal law of gravity. Do you believe your home loan or car loan or loan against property has tended to defy this law of gravity? Do you feel that the rate only floats up and rarely, if at all, floats down? You may be right, and here’s why.

 A floating rate loans will have one of the following as its benchmark
   :: The prime lending rate (PLR) in case of loans from NBFC’s and housing finance companies
   :: The base rate in case of loans from banks (starting 1st July 2010)
 
The principle - Interest on floating rate loans consists of two parts – a benchmark and a spread. The benchmark rate is supposed to reflect the market movement in interest rates and accordingly the applicable rate on a floating rate loan is supposed to float.
 
The Practice – First, let’s talk about PLR benchmarked loans:
 
:: The PLR is set by the lenders themselves and not by a third party or a market regulator. Hence, lenders may be prompt at increasing benchmark rates but slow in reducing them.

::PLR based loans are mostly priced at a discount to the PLR – what it means is that the loan that is offered at say, 10.25%, is priced as PLR of, say 16% and a negative spread of 5.75%, taking the net to 10.25%. When market interest rates go up, lender increases the PLR and the applicable rate for all existing loans goes up. However, when interest rates trend downwards, the lender may not change the benchmark (PLR) but may simply increase the negative spread for new customers, thereby benefitting new borrowers and still charging higher rates to the old borrowers.


Lets explain this with an illustration. Say, a lender gave a home loan at 10.25% six months back, pricing it at PLR of 16% and a negative spread of 5.75%. Now, in case the interest rates in the market move up by 0.50%, the lender will increase the PLR to, say 16.50%, thereby increasing the applicable rate on the home loan to 10.75% (calculated as 16.50% less 5.75%). However, in case the interest rates in the market were to trend downwards by 0.50%, the lender may keep the PLR unchanged. Thereby, the existing loan holders will continue to pay the old interest of 10.25%. In order to compete in the market and acquire new customers, the lender will offer new loans at 9.75% priced as PLR of 16% and negative spread of 6.25% instead of 5.75% earlier.

:: This is why it has been observed that the PLR of banks and other lenders tend to be rather sticky.

:: In order to prevent the customer from changing to another lender at lower rates, the lenders used to impose prepayment charges even on floating rate loans. Now the RBI has banned prepayment and foreclosure charges on floating rate loans to individual borrowers. This move has made it possible for people to avail home loan balance transfer or loan takeover without paying penalty and thus save interest cost.

 Now, lets talk about the base rate bench marked loans 
The base rate system was introduced by the RBI from 1st July 2010. Just like the PLR, base rate is also a benchmark rate but with one key difference – base rate is the minimum rate below which no bank can offer any loan. We will explain you the importance of this one difference and how it helps you save money.

    Let’s go back to our earlier example of a home loan availed at 10.25%, this time under the base rate system. As we said, banks cannot lend below the base rate. So, if the applicable rate on your home loan is 10.25%, the bank’s base rate at this time must be less than 10.25%. Say, the base rate of this bank at the time of disbursing this home loan was 10.0%. So, the loan was priced as base rate of 10% and spread of 0.25%. When market interest rates go up, bank increases the base rate and the applicable rate for all existing loans goes up. When interest rates trend downwards, the bank has no choice but to reduce the base rate as it is not allowed to lend below the base rate. Thus, any benefit of lower rates will have to be passed to both old borrowers and new borrowers.

    Lets again look at our earlier illustration. Say, the bank gave a home loan at 10.25% six months back, pricing it at base rate of 10% and a spread of 0.25%. Now, in case the interest rates in the market move up by 0.50%, the bank will increase the base rate to, say 10.50%, thereby increasing the applicable rate on the home loan to 10.75% (calculated as 10.50% plus 0.25%). However, in case the interest rates in the market were to trend downwards by 0.50%, the bank will have to price its new home loans at 9.75% to be competitive in the market. However, the bank can do so only if it reduces its base rate to at least 9.75%. Most likely, the bank will have to reduce its base rate by 0.50% and pass the benefit to both old and new borrowers.

    So, the base rate benchmarked loans provide a better and more transparent interest rate transmission for the borrower. But there is a catch!

Some banks (a handful of them) have taken a view that not only the base rate but even the spread over the base rate in case of a floating rate loan can be kept variable. One wonders how one would call this a “benchmarked” loan. This practice of a few banks has caught the attention of the RBI and the latest recommendations have suggested banning this practice.

The base rate regime is applicable only to banks and not to NBFC’s and HFC’s.
So, when you take a floating rate loan, please check the following five things:
What is the benchmark rate – PLR or base rate?
What is the spread – positive or negative? 
Is the spread fixed for the loan tenure or is it variable?
What is the track record of this lender/ bank’s benchmark rate – how often has it changed
What will be the loan tenure – not just at the interest rate but also if the rate goes up or down by upto 1%

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