Loans Linked To External Benchmarks: What’s The Impact?

According to the new guidelines set by the Reserve Bank of India (RBI), all new floating-rate retail loans including home loan, auto loan, and personal loan will be linked to external benchmarks from April 1, 2019. The benchmarks will include either RBI’s policy repo rate, 91 days Treasury bill, 182 days Treasury bill, or any other benchmark of the Financial Benchmarks India Private Ltd. These benchmarks aremarket-linked and will change more often than your Marginal Cost of Lending Rate (MCLR) that banks and other financial institutions are using currently.

Loan rate

  • The loan rate will be the benchmark rate plus a spread
  • This spread over the benchmark rate will be decided by the bank
  • It will be set at the time you avail the loan
  • This spread will remain the same throughout the life of the loan unless the borrower’s credit valuation undergoes a substantial change as mentioned in the loan contract.

Impact of loans linked to external benchmarks

  • Now, since the interest rates will be linked to the benchmarks, they are going to reflect market rates very quickly. Therefore, at the time of repayment of the loan, you will be paying more in interest sooner rather than later.
  • As these benchmarks are market-linked, they are going to be highly volatile. Therefore, RBI has to allow a reset frequency that is different from these benchmarks. Even a 3 or 6 months reset frequency can affect your EMIs heavily.
  • Another point to be noted is that the benchmark rate system is only applicable if you are borrowing from banks. RBI hasn’t made any comment about rates set by NBFCs and other HFCs. Therefore, you will have to compare rates across the board in order to avail the best rate for your loans.
  • More clarity is needed regarding how the benchmark rate will be calculated. Will it be an average of the rates during a period or the rate at the end of a specific period?Given the volatility of these benchmarks, it is more likely that the benchmarks would be an average of the rates. But that period has to be long since loans are taken for long terms and regular changes in loan EMI or term will create problems for the borrower.

This year, the Treasury bill (T-bill) rates have risen faster than the repo rate and the MCLRs of banks. Therefore, if the loan rate is linked to the T-bill rate, you might have to pay a higher interest even before RBI actually hikes interest rates.

Therefore, if you are looking for a home loan this might be the right time because the interest rates are going to increase significantly. Moreover, you can take advantage of the Pradhan Mantri Awas Yojana (PMAY) subsidy that has been extended till 31st March 2019.

If you are an existing home loan borrower looking for better interest rates, it is recommendedthat you wait until RBI clarifies how the new benchmark system will work.