If the Reserve Bank of India's (RBI) draft guidelines on credit pricing are implemented, home loan borrowers will be able to get these at rates depending on their risk profile. Borrowers will know why a certain bank is offering them loans at a particular rate while another is charging more. It will also be easier to shift, especially home loans, from one bank to another.
Last week, RBI released the draft report of its 'Working group on pricing of credit'. The report tries to address issues like the downward stickiness of interest rates, discriminatory treatment of old borrowers compared to new ones, arbitrary changes in spreads and so on.
"Despite the policy efforts to usher transparency and fairness to the credit pricing framework, there have been certain concerns from the customer service perspective," says the report. So, how will these guidelines, as and when implemented, help retail borrowers?
"Globally, banks are moving toward risk-based pricing. If you consider a client more riskworthy, you should not charge him or her as much as a riskier one. The more number of interest rate buckets you have, the more the risk grading and the better will be risk migration," says Robin Roy, associate director at PricewaterhouseCoopers.
RBI also says the spread charged to an existing customer cannot be increased, except on account of deterioration in the credit risk profile.
Apart from data on default or delay on repayment of loans, credit bureaus may also look at data such as instances of cheque bouncing and payments to utilities, to determine the scores of borrowers, says a public sector bank (PSB) official. "Banks will now look at data from credit bureaus more dynamically," he says. But it will take time for bureaus to collect this data, since they don't do it currently.
Based on the data of instances of default, banks may offer better interest rates to home loan borrowers from a particular industry, the official adds.
Transparency in loan pricing
The guidelines put a lot of emphasis on transparency. For instance, it suggests the spread charged to an existing customer cannot be increased, except on account of deterioration in the credit risk profile. The customer should be informed of this at the time of the contract and this information should be adequately displayed.
Banks should publish interest rates, fees and charges on their websites for transparency, comparability and informed decision making by customers. Banks should also disclose the interest rate range of contracted loans, for the past quarter for different categories of loans along with the mean and median interest rates charged. Fees and charges must be clearly disclosed at the time of account opening and made available to the customers at all times through various communication channels, says RBI.
The floating rate loan covenant may have the interest rate reset periodicity and the resets done on those dates only, irrespective of changes to the base rate within the reset period.
Ashvin Parekh, managing partner of Ashvin Parekh Advisory Services, says these steps will ensure the cost of inefficiency cannot be transferred to borrowers.
"As a borrower, I have to completely understand why I am paying 'X' rate to a particular bank and 'X+1' rate to another bank. And, as much as a customer has to be transparent, so should banks," he says.
To help borrowers compare costs across products and lenders, RBI suggests banks provide a range of annual percentage rate (APR) or similar other arrangement of representing the total cost of credit on a loan on an annualised basis. However, the applicable APR should get crystallised in the loan covenant with the consumer.
Differential pricing for loans with exit option
RBI also suggests for retail loans, customers have 'with exit' and 'sans exit' options at the time of entering the contract. The exit option can be priced differentially but reasonably. "The exit option should be easily exercisable by the customer, with a minimum notice period and without impediments. This would address issues of borrowers being locked into contracts, serve as a consumer protection measure and help enhance competition. Further, Indian Banks' Association should evolve a set of guidelines for easier and quicker transfer of loans, particularly mortgage/housing loans. There could also be penalties for banks which do not cooperate with borrowers in this regard," says RBI.
According to the PSB official quoted above, when a loan is pre-paid, banks could face asset-liability management mismatches. That is why in many cases, banks try to stop customers from switching loans. These guidelines mean banks can charge a higher rate to those borrowers who wish to prepay or maybe say they will not allow pre-payment for an initial period of two-to-three years.
"With the pre-payment penalty being abolished, now banks may try to give incentives to 'sans exit' by offering lower rates. But the differential between 'exit and 'sans exit' should be reasonably attractive for borrowers," he adds. "For 10-15 basis points, it is unlikely that borrowers will shift."
The benefit of interest reduction on the principal on account of prepayments should be given on the day the money is received by the bank, without waiting for the next equated monthly instalment (EMI) cycle date to effect the credit, says RBI.
Currently, if you make a prepayment on the fifth of a month and your next EMI is due on the 25th, the interest will be calculated only from the 25th. You lose the benefit of the 20 days in between. If the new rule is implemented, the interest will have to be calculated from the day you make the pre-payment.
"Most banks work on an accrued interest basis. So, the EMI is calculated on daily reducing balance computed monthly. Very few calculate it on a daily basis. For the new rule, banks will require huge system changes, so implementing it might be difficult," says Vipul Patel of Home Loan Advisors, a mortgage advisory firm.
Last week, RBI released the draft report of its 'Working group on pricing of credit'. The report tries to address issues like the downward stickiness of interest rates, discriminatory treatment of old borrowers compared to new ones, arbitrary changes in spreads and so on.
"Despite the policy efforts to usher transparency and fairness to the credit pricing framework, there have been certain concerns from the customer service perspective," says the report. So, how will these guidelines, as and when implemented, help retail borrowers?
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One suggestion is that loan rates be based on risk premium of the borrower. This means banks will utilise data from credit information bureaus more dynamically. Currently, credit bureaus give scores to customers based on their default and banks give a score based on their internal ratings. However, this score is largely used for either approving or rejecting the customer. Going forward, each borrower will be given scores by banks based on both internal and external score and the final loan rate will be based on both.
"Globally, banks are moving toward risk-based pricing. If you consider a client more riskworthy, you should not charge him or her as much as a riskier one. The more number of interest rate buckets you have, the more the risk grading and the better will be risk migration," says Robin Roy, associate director at PricewaterhouseCoopers.
RBI also says the spread charged to an existing customer cannot be increased, except on account of deterioration in the credit risk profile.
Apart from data on default or delay on repayment of loans, credit bureaus may also look at data such as instances of cheque bouncing and payments to utilities, to determine the scores of borrowers, says a public sector bank (PSB) official. "Banks will now look at data from credit bureaus more dynamically," he says. But it will take time for bureaus to collect this data, since they don't do it currently.
Based on the data of instances of default, banks may offer better interest rates to home loan borrowers from a particular industry, the official adds.
Transparency in loan pricing
The guidelines put a lot of emphasis on transparency. For instance, it suggests the spread charged to an existing customer cannot be increased, except on account of deterioration in the credit risk profile. The customer should be informed of this at the time of the contract and this information should be adequately displayed.
Banks should publish interest rates, fees and charges on their websites for transparency, comparability and informed decision making by customers. Banks should also disclose the interest rate range of contracted loans, for the past quarter for different categories of loans along with the mean and median interest rates charged. Fees and charges must be clearly disclosed at the time of account opening and made available to the customers at all times through various communication channels, says RBI.
The floating rate loan covenant may have the interest rate reset periodicity and the resets done on those dates only, irrespective of changes to the base rate within the reset period.
Ashvin Parekh, managing partner of Ashvin Parekh Advisory Services, says these steps will ensure the cost of inefficiency cannot be transferred to borrowers.
"As a borrower, I have to completely understand why I am paying 'X' rate to a particular bank and 'X+1' rate to another bank. And, as much as a customer has to be transparent, so should banks," he says.
To help borrowers compare costs across products and lenders, RBI suggests banks provide a range of annual percentage rate (APR) or similar other arrangement of representing the total cost of credit on a loan on an annualised basis. However, the applicable APR should get crystallised in the loan covenant with the consumer.
Differential pricing for loans with exit option
RBI also suggests for retail loans, customers have 'with exit' and 'sans exit' options at the time of entering the contract. The exit option can be priced differentially but reasonably. "The exit option should be easily exercisable by the customer, with a minimum notice period and without impediments. This would address issues of borrowers being locked into contracts, serve as a consumer protection measure and help enhance competition. Further, Indian Banks' Association should evolve a set of guidelines for easier and quicker transfer of loans, particularly mortgage/housing loans. There could also be penalties for banks which do not cooperate with borrowers in this regard," says RBI.
According to the PSB official quoted above, when a loan is pre-paid, banks could face asset-liability management mismatches. That is why in many cases, banks try to stop customers from switching loans. These guidelines mean banks can charge a higher rate to those borrowers who wish to prepay or maybe say they will not allow pre-payment for an initial period of two-to-three years.
"With the pre-payment penalty being abolished, now banks may try to give incentives to 'sans exit' by offering lower rates. But the differential between 'exit and 'sans exit' should be reasonably attractive for borrowers," he adds. "For 10-15 basis points, it is unlikely that borrowers will shift."
The benefit of interest reduction on the principal on account of prepayments should be given on the day the money is received by the bank, without waiting for the next equated monthly instalment (EMI) cycle date to effect the credit, says RBI.
Currently, if you make a prepayment on the fifth of a month and your next EMI is due on the 25th, the interest will be calculated only from the 25th. You lose the benefit of the 20 days in between. If the new rule is implemented, the interest will have to be calculated from the day you make the pre-payment.
"Most banks work on an accrued interest basis. So, the EMI is calculated on daily reducing balance computed monthly. Very few calculate it on a daily basis. For the new rule, banks will require huge system changes, so implementing it might be difficult," says Vipul Patel of Home Loan Advisors, a mortgage advisory firm.