What has the RBI asked banks and NBFCs to do at the time of sanctioning personal loans?

In a welcome move for retail borrowers, the Reserve Bank of India came out with norms for reset of floating interest rate on EMI based personal loans (read: retail loans). Accordingly, at the time of sanctioning these loans, regulated entities (REs), which include banks and NBFCs, are required to communicate to the borrowers about the possible impact of change in benchmark interest rate on the loan leading to changes in EMI and/or tenor of the loan.

Any change in these parameters should be immediately communicated to the borrower. Also, at the time of reset, the lender should provide the option to the borrowers to switch over to a fixed rate from floating rate. REs need to have a board-approved policy for such instances, which may also indicate the number of times a borrower may switch the interest rate mechanism during the tenor of the loan.

What is the current practice adopted by regulated entities when interest rates move higher?

Interest rate hikes gripped lenders and borrowers quite unexpectedly last year, just around the time when the banking sector and retail borrowers were returning back to health. Therefore, since May 2022, it’s been noticed banks increase the tenure of loans; the objective being to keep the EMI affordable. During October-December, when rates kept increasing and the tenure of loans had been lengthened as much possible, banks started passing on the higher interest rate to customers. NBFCs, on the other hand, passed on the rates instead of increasing the tenure since the start of rate reversal cycle. That said, non-banks have greater share of MCLR (marginal cost of lending based rate) and fixed rate loans compared to banks.

What options are given to borrowers currently when the interest rates move higher?

At present, the borrowers are only informed whether the REs have decided to extend the tenure and/or increase the EMI; the borrower does not have an option to choose. However, one may approach the lender in person get the loan contract re-jigged as per his/her preference.

Why is RBI issuing this directive?

There were instances of borrowers aged 50 years and loan outstanding for the next 15 years witnessing the tenure getting elongated by another 15 years because of rate hikes. In such a case, he would have the debt obligation hanging even after turning 80 years, while the active earning years would have ended by 60-65 years. It’s also possible that the EMI may still not cover the interest rate hike, leading to a situation of negative amortisation. The intent of the RBI through this directive is to curb such anomalies.

Are these rules favourable for borrowers?

Yes and no. Certainly, it would increase transparency and educate borrowers on what they are signing up for. But higher interest rates cannot be avoided. Further, opting for fixed rate loans over floating may not be viable because the price differential between the two is at least 500 basis points.

For instance, when the interest rates were lowest in December 2021, floating rate home loans started at 6.5 per cent while fixed rate was priced at 11-12 per cent. Therefore, this directive cannot be used an option to lock in rates advantageous for borrowers. Also, foreclosing loans is a tedious process and involves costs. Hence, beyond theoretically having the option of switching, to do so in practice may be a long shot.

How should borrowers decide if they want to pay higher EMI or elongate the loan tenure?

This is a function of monthly cash-flows and the outstanding loan and tenure. If the amount and tenure outstanding aren’t very long, then the borrower could stomach a higher EMI so that the loan is paid off within time. If the borrower has issues with monthly income, opting for longer tenure makes sense.