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External Factors

Does it make sense to opt for external benchmark-linked loans?

After getting delayed by six months from the original implementation date of April 1, external benchmark-linked floating rate loans became a reality on October 1. All banks have now started offering retails borrowers floating rate loans linked to external benchmarks. The Reserve Bank of India (RBI) had been pursuing this for long to improve the way banks change interest rates for retail loans.

"There are multiple benefits for borrowers of loans linked to external benchmarks. For starters, it drives transparency for all borrowers (new or old), and builds standardisation," says Shantanu Sengupta, Managing Director and Head-Consumer Banking Group, DBS Bank India. "Earlier, only new borrowers got the benefit of better rates in a declining interest rate scenario while old loans used to run at higher rates. The new regime of external benchmark-linked loans with a fixed spread ensures better transmission across borrowers with similar risk profiles," he adds.

How do these loans work? How will they impact your loans? Do you stand to gain from this change or not?

Benchmark and Your Home Loan

The frequency of interest rate revision will depend upon the changes in the benchmark. As the majority of the banks have selected the repo rate as their external benchmark, your home loan rate will change as per the changes in the repo rate. According to the RBI guidelines, banks will set the external benchmark rate at the beginning of a quarter, and it will remain there for the next three months.

As the RBI's Monetary Policy Committee meets every two months, the repo rate decided at the previous MPC at the beginning of a new quarter will be applicable for the next three months. For instance, for the October-December quarter, State Bank of India took a repo rate of 5.4 per cent (prevailing till September) as the benchmark for its floating rate loans. The MPC reduced the repo rate to 5.15 per cent on October 4, but there is another meeting scheduled in December. So, for quarter beginning January 2020, the repo rate decided on December 5, 2019, will be taken as the benchmark. If there is no change in that meeting, borrowers will see a 0.25 per cent reduction in rates.

You do not need to depend on your bank to tell you the rates. Just follow the changes in the benchmark. "As loans linked to external benchmarks will see faster transmission of policy and other broader market interest rates than in the previous regimes, existing borrowers switching to external benchmarks will witness a faster reduction in interest rates in the event of a reduction in policy rate or other broader market rates," says Naveen Kukreja, CEO and Co-founder,

With repo rate, banks may not be able to delay the rate transmission by more than three months or beginning of the next quarter. "However, the opposite will hold true in case of rising interest rates. Those with loans linked to external benchmarks might witness a faster increase in their loan rate than those under MCLR (Marginal Cost of Funds Lending Rate) and other older interest rate setting mechanisms. Hence, those comfortable with frequent and swift changes in their interest rates can consider shifting to external benchmarks," he adds.

Change in Spread

The cushion that a bank keeps above its external benchmark rate is called the spread. There may be other mark-ups above this. "Banks decide their spread over floating rate loans based on their operating cost, cost of funds, expected rate of return, market competition, etc. Any changes in these factors can influence banks to change their existing spreads," says Kukreja. SBI, for instance, has kept a spread of 2.65 per cent above the repo rate.

"For spreads charged to existing borrowers under external benchmarks, RBI guidelines allow banks to change the spread once in three years," adds Kukreja. Once decided, the spread cannot be changed for three years. Therefore, any change in the spread which can substantially impact the effective home loan rate will happen only after three years of the last change.

Advantage MCLR loans

In the past few years (three-and-a-half years), the difference between SBI's MCLR and the corresponding repo rate kept changing. While in April 2016, the difference was 2.7 per cent, it came down to 1.95 per cent in November 2017. But the current difference is much higher - 2.9 per cent. This means that the external benchmark rate has been introduced at a time when the difference between the repo rate and the bank's MCLR is at its peak. This is why it has translated into most banks charging a higher spread, mostly above 2.5 per cent. And as this spread will remain unchanged for the next three years, the trend suggests that if the mark-up in both cases is the same, those who have MCLR-linked loans stand to benefit whenever the difference narrows.

Plus, since MCLR is revised monthly, borrowers with MCLR loans may benefit early while borrowers with external benchmark-linked loans will have to wait for three years, which is when the spread can be revised.

Before deciding to switch to an external benchmark-linked loan, take a look at the details such as effective interest rate and when you will be able to actually avail the benefit of a lower rate.

Credit Score to Play a Role

If you enjoy a high credit score, you can now get a lower interest rate on your loan. "Banks are using credit scores and/or their own internal credit risk grading systems to determine risk-based premiums in floating rate retail and MSME loans under the external benchmark regime. For example, for home loans, SBI charges a risk-based premium based on its own risk grading system whereas some like UCO Bank, Bank of India and Union Bank of India use CIBIL scores," says Kukreja.

Bank of Baroda has come up with a transparent system for charging credit premium. "We have kept the working very simple for greater transparency at the customer level. We have benchmarked the risk premium based on bureau score (currently CIBIL) and at different grids. For 725-759 (credit score), we charge a risk premium of 0.25 per cent," says Virendra Sethi, Head-Mortgages and Other Retail Assets, Bank of Baroda. So, if your CIBIL score is 760 or above, you will get the best rate, which is 8.1 per cent. If it is below 760, but not below 725, an additional 0.25 per cent interest will apply and your rate will become 8.35 per cent. If the score is below 725, you will end up paying 9.1 per cent.

Union Bank of India has also selected CIBIL score as a criteria to determine risk categories. It has kept the score of 700 as a cut-off, so anyone with a credit score of 700 or more can get the best rate of 8.20 per cent. Customers who have a lower score may have to pay 0.10 per cent more, and their effective home loan interest rate would be 8.30 per cent.

A good credit score will come handy throughout the repayment period as well; if the score falls significantly, the bank may add a premium and increase the interest rate.

"The premium would be fixed for auto and personal loans, but in case of a home loan, the review will be done on the anniversary of the loan," says Sethi of Bank of Baroda.

Selecting the Best Loan

It's easy to compare rates of different banks when the external benchmark remains the same. "Borrowers would now find it easier to choose the best option as most banks are using the repo rate as the external benchmark. The only difference to look out would be the 'fixed spread' and the 'credit risk premium'," says Sengupta of DBS Bank India.

A bank with the lowest spread which offers you the best credit premium will give you the lowest rate. And this will remain the same for at least three years. After that, if your rate increases, you can shift to another bank as there is no penalty for transferring a floating rate loan.

While new borrowers have no choice but to go for floating rate loans linked to an external benchmark, old borrowers can choose to continue with the old system (MCLR) or shift to the new one. "Existing borrowers under older interest rate regimes can switch to external benchmark without incurring any charges except for the administrative and legal costs incurred," says Kukreja. The charges are often nominal. In Bank of Baroda, for example, "one needs to pay  Rs 2,500 as a one-time administrative fee (for the shift)," says Sethi.

If your bank is charging a high mark-up over MCLR or base rate, as a result of which your effective interest rate is high, it makes sense to consider shifting to external benchmark-linked loans. But if you have a lower mark-up and an overall competitive rate, it may be worthwhile to wait. Keep comparing your interest rate with that of external benchmark-linked loans. And since it costs to shift loans, do an overall cost benefit analysis. Whenever you find that there is an advantage of more than 0.25 per cent in the interest rate, you could consider shifting your loan to external benchmark.