Are fixed-floating rates a sound option for retail home loan borrowers?

Two leading industry experts debate the merits and demerits of the new fixed-floating rate product that the SBI chairman proposed recently

State Bank of India (SBI) chairman Rajnish Kumar recently spoke about seeking a clarification from the Reserve Bank of India (RBI) on launching long-term home loan products that would initially have a fixed rate and would then move to a floating rate.

His proposal has revived memories of a home-loan product SBI had pioneered in 2009, which was popularly known as “teaser loan”. This product offered customers a home loan at a lower rate of interest initially. Once that period got over, the customer was moved to the market-linked floating rate existing then. The idea was that it would enable younger couples to take a loan and buy a house at an early age. The two- or three-year breather they got would enable them to build a corpus, or their salaries would grow sufficiently so that they would be able to bear the higher EMI when their home-loan rate became market-linked.  

The RBI, the banking regulator, however, did not take kindly to these products. In order to discourage banks, it hiked the risk weightage—the amount of capital that banks have to keep aside—on such loans five-fold from 0.40 per cent to 2 per cent. It also asked them not to cross the loan-to-value (LTV) ratio of 80 per cent.

The fear then about teaser loans was that they kick the can down the road, or defer risk to a later date. They lure borrowers to take home loans at a lower initial rate. Many of these borrowers would find it difficult to service their equated monthly instalments (EMIs) when the market-linked floating rate kicked in. Banks had argued that they carry out due diligence and only offer these loans to those whom they found eligible. Hence, they said, the RBI’s fear that such loans could prove risky was unfounded. Ultimately, however, taking the hint from the regulator, banks discontinued this product.  

Many readers have asked us this question: Is the fixed-floating rate loan being proposed by the SBI chairman any different from teaser loans? And will they be good for retail borrowers? Let us hear what the experts have to say about these loans.

Fixed-floating rate loans will make sense for most retail borrowers: Abizer Diwanji, Partner and National Leader, Financial Services, EY India, EY

The fixed-floating rate home loan product that the SBI chairman is talking about is not like the teaser loans of the past. In a teaser loan, the customer starts with a lower interest rate, which then keeps increasing with the passage of time. This means that his EMI also increases at intervals.

Floating-fixed rate loans are more of a treasury call. By fixing the interest rate for a certain period of time, say two-four years, the bank takes the interest-rate risk upon itself. It is the ability of a bank to take this risk that allows it to offer such a product.

In a fixed-rate loan, the EMI remains constant and the principal and the interest component get amortised at the same rate over, say, 30 years. In a floating-rate product, on the other hand, the interest rate keeps fluctuating in tandem with interest-rate movements within the economy. Now, public-sector banks like SBI have linked their home loan rates to the repo rate. So, as the repo rate goes up and down, the interest component of the EMI will also rise and fall while the principal will keep getting adjusted.

Internationally, when banks offer a fixed-rate product, they do so at a slight premium to the interest rate they charge on a floating-rate loan. Banks, on their part, also hedge their interest-rate risk. They then add the cost of hedging when deciding the interest rate they will charge on the fixed-rate product. By hedging, they transfer interest-rate risk off their books.

These loans also allow banks to manage their interest-rate risk better. They bear the risk for a limited period of time. And once the customer moves to a floating rate after a few years, the risk gets transferred to him.  

For non-savvy borrowers, a fixed-floating rate product makes a lot of sense. They will be able to do away with interest-rate risk on their home loan for some period of time. This will lend stability to their financial plans. Internationally, you even have products where the customer does not move to a floating rate after the initial fixed-rate period ends. Instead, he has the option to move to another period for which his loan rate remains fixed, though at a new rate of interest. Even that is a good option.

Most retail borrowers should opt for such a fixed-floating rate loan product even if they have to pay a slight premium. It is difficult for most borrowers to take a call on interest-rate movements.

As for savvy borrowers, if they believe that interest rates are set to decline, they may opt for a floating-rate product. On the other hand, if they believe that rates will rise, they too could opt for a fixed-floating rate product.

Prepaying khichdi loans early will entail a cost: Harsh Roongta, Sebi-registered investment advisor 

The media has reported that SBI has sought the views of the RBI on its proposal to offer home loans that have a fixed rate of interest for the first few years and a floating rate thereafter. The exact contours of the proposed home loan are not known. The last time SBI had a structure like that, it was the (in)famous teaser rate loan regime of 2010-2011, where it offered attractive low fixed rates for the first two-three years and then a vague floating rate after the initial fixed-rate period got over. In fact, somebody who took a Rs 30 lakh home loan in the teaser rate regime in June 2010 is currently paying through his nose at an interest rate of 11.30 per cent per annum. Clearly, whoever else benefitted from the teaser rate loans, it was not the home loan borrower.

A key point to remember is that if a khichdi loan is prepaid during the time when the fixed-rate option is still applicable, then the RBI’s stipulation of no prepayment charges will not apply. All in all, the khichdi loan option was like the proverbial chakravyuh – you could enter it but the cost of exit was high.

While it is not clear what kind of approval has been sought by SBI, there are two significant issues surrounding such khichdi loans. First, the RBI is unlikely to approve low fixed rates for the initial years (a la teaser rate loans), which means that the initial fixed rates are likely to be close to market rates. In an environment where interest rates look likely to go down rather than up, this would be a terrible deal for borrowers, especially since prepayment may also entail prepayment charges. Second, if such a loan is approved by the RBI, then SBI may undersell its regular floating rate home loan product (just like it undersold the short-lived repo rate linked loan rate or RLLR product), with the result that a large number of home loan borrowers may be saddled with a burdensome high-rate loan even as market interest rates head lower. In fact, if approved, such a strategy would allow the bank to neatly side step the RBI’s need for monetary transmission of lower rates.

Given the lack of consumer protection legislation in India, any complicated product just cannot be customer friendly. Hopefully the RBI will understand this and not permit any such khichdi loan product.