RBI’s external benchmark for loans: The good and the bad for borrowers

BL Research Bureau

Lending rates on your home, vehicle and personal loans could get cheaper. The RBI on Wednesday mandated all banks, including small finance banks, to link new floating rate personal, retail loans and floating rate loans to MSMEs to an external benchmark effective October 1, 2019 . Up until now, loans were linked to bank-specific benchmarks-- MCLR (marginal cost of funds based lending rate). Given that banks have been tardy in cutting MCLR and hence lending rates, borrowers have had little respite.

The new mandate that requires banks to link lending rates on certain loans to external benchmarks – repo rate, 3-month treasury bill yield or 6-month Treasury Bill yield — can lead to lower loan rates right away.

But aside from rates, there are several other nuances in the new structure that borrowers need to be wary of.

Better transmission

If you are looking at a floating rate loan for buying a new house or vehicle, then you need to first understand that banks peg their lending rates on such loans, against a particular benchmark. Until now, each bank decided its own benchmark, based on their cost of deposits or borrowings. Under the existing MCLR structure, banks calculate their cost of funds based on the latest rates offered on deposits or borrowings. Given that each bank’s cost is different, MCLR also varies across banks.

Ideally when the RBI cuts or hikes repo rate, banks’ MCLR should also move in tandem. But given that banks only source a small portion (1 percent) of their deposits at the RBI’s repo rate, banks’ cost of funds reduce or increase by a smaller amount (than repo rate movement), limiting the changes in MCLR.

With the RBI mandating that all banks peg lending rates to an external benchmark, say the repo rate, RBI’s rate actions can get transmitted almost immediately.

Let us take the case of State Bank of India (SBI). It introduced the repo linked loan product for home loans from July this year. Lending rates are benchmarked against repo rate lending rate (RLLR), which changes every time the RBI tweaks its repo rate.

RLLR changes from the 1st of the following month in which the RBI changes its repo rate. With the RBI’s 35 bps repo rate cut in August, SBI’s RLLR has reduced to 7.65 per cent since September 1 (from 8 per cent earlier). Hence for home loans upto ₹75 lakhs, the effective lending rate for borrowers with good credit score works out to 8.05 per cent (mark-up of 40 bps over RLLR) currently.

SBI’s MCLR linked home loan has an effective lending rate of 8.65 per cent.

Bottomline: Loans under the new external benchmark structure would get cheaper and fast, if the RBI continues to cut rates. On the flip side, be prepared for a higher payout, when the RBI starts to hike rate.

Also read: External benchmarking good news for customers but banks remain cautious

Mind the initial base and spread

While, by design, external benchmarks should be lower than existing MCLR in a particular bank, borrowers should be wary of two things.

One, even if banks link lending rates to the same external benchmark, the initial base or benchmark would vary across banks. For instance, let us take the case of SBI and IDBI. Both banks have already linked their home loans to repo rate. But their repo rate lending rate (RLLR) varies. For SBI while the RLLR is 7.65 per cent currently, IDBI Bank it is 8.3 per cent.

While any move by the RBI in future will see lending rates move higher or lower by the same quantum in both banks, since the initial base is different, the effective lending rate would vary. Hence, borrowers will still have to compare the underlying benchmark across banks to zero in on the cheapest option.

Two, banks arrive at the effective lending rate by assigning a mark-up or spread over the benchmark. This could also differ across banks. In case of SBI for instance, while the spread is 40 bps, in case of IDBI Bank the spread charged over and above its RLLR is nil in case of borrowers with a high credit score of 750 and above. Though the effective lending rate for SBI still works out cheaper, borrowers need to take note of the mark-up at all times.

While the RBI has mandated that banks cannot change the spread unless there is a change in borrower’s credit assessment, adhoc practices followed by banks in the past, warrant a close look at the spread charged by banks.

Bottomline: Take note of the underlying benchmark and spread at the start of the loan, and then compare across banks.

Reset rules

Under MCLR, lending rates are reset only at intervals corresponding to the tenure of the MCLR. For instance, in the case of home loans benchmarked against the one-year MCLR, lending rates are reset every year.

Under the external benchmark structure the RBI has mandated that loans are reset at least once in three months-- provided of course that there are changes in the underlying benchmark repo or t-bill yield. This means that your lending rate will be revised much faster. In case of SBI’s home loan product, changes to lending rates happen immediately (within a month of change in RBI’s repo rate).

Aside from quicker transmission, this also implies other changes in your monthly pay outs.

Read | Speeding up: An external benchmark may lead to faster transmission, provided banks play by the rules

Under a regular home loan product, one that is linked to your MCLR, your equated monthly instalment (EMI) on your home loan is fairly stable. Even when the lending rate is reset based on the latest MCLR, banks usually change the tenure (lower the tenure in case of fall in rates) of your loan rather than EMI -- unless you specify otherwise. This in effect keeps your EMI steady.

Under SBI’s RLLR however, a minimum 3 per cent of the principal loan amount is repaid every year. Interest charged on the loan is serviced monthly, based on the lending rate effective at that point in time. Hence your EMI changes every time there is a change in RBI’s repo rate (in the following month).

For now, it is unclear how other banks will structure their products under external benchmarks (they could offer a steady EMI).

Bottomline:Look at individual products and understand their structure before deciding, if predictability in EMIs is important to you.

Old borrowers can move

The RBI has allowed existing borrowers under MCLR to move to the external benchmarked-loans, without levy of any charges or fees. Given that loans under the new structure will most likely be cheaper than under MCLR, in a particular bank, borrowers should consider making the switch. However, do take note of any hidden charges (RBI has allowed some administrative/ legal costs) before making the move. Also, ensure that you are offered the same lending rate as a new borrower under the external benchmark regime.

It may be prudent to also weigh in the benefits. If you are nearing the end of your existing loan, it may not make sense to make the switch. If you do not care much for volatility in your EMIs, then consider the move only if the interest savings are substantial.

Also, as of now it appears that the no-charge/fee mandate applies only to switch between the same bank. If you are making a move from one bank to another, there could be additional charges.

Bottomline: Switch to external benchmark loans if the remaining tenure of your loan is long and interest savings are substantial.

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