Explained: Borrowers can change tenures, EMIs, switch to fixed rates during loan resets

In order to enhance consumer protection, India's central bank is implementing a system requiring banks to provide timely and transparent communication with borrowers regarding any changes to the tenor and/or EMI of their home loans.

 Additionally, the RBI has mandated that lenders offer borrowers the ability to switch to fixed-rate home loans or foreclosure of loans at their discretion, with full disclosure of any related fees or charges. 

The Reserve Bank of India (RBI) on Friday asked all banks and and non-banking financial corporations to give personal loan borrowers an option to switch over from a floating rate to a fixed rate regime at the time of resetting interest rates.  Borrowers will also be given the choice to opt for enhancement in EMI or elongation of the tenor.

According to RBI personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).
 

 

Interest rates have risen since May last year as the central bank hiked the repo rate to tame high inflation. As a result of 250 basis points increase in the repo rate from May 2022 till February this year, a large number of borrowers have been facing negative amortisation, wherein the Equated Monthly Instalment (EMI) works out to be less than the interest obligation, resulting in persistent increase of the principal amount.

 The RBI mandate in a nutshell
RBI has now made it mandatory that at the time of sanctioning a loan, the bank will have to convey in writing to the borrower the impact of a rate change. So, whenever the repo rate is hiked by the RBI, the lender will have to provide an option to the borrower if he wants to increase the EMI or the tenor. Similarly when the RBI cuts rates, banks will have to ask the borrower if he wants a lower EMI or a reduced tenure.

If RBI increases interest rates, lenders have to ensure the EMI continues to cover the monthly interest on the loan and the loan outstanding does not increase from the previous month's level after EMI is paid. 

Also, loan sanction letters will have to disclose the charges for switching a loan from floating to a fixed rate at a future date. 

RBI has barred lenders from charging loan customers penal interest rates, and said they could only charge a penalty for non-compliance of terms and conditions

“Penalty, if charged, for non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’, and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances,” the RBI said.
 

" RBI has been very clear on separating penal charges and penal interest charged to the customers. The Credit Card and Debit Card – Issuance and Conduct Directions, 2022 master circular in December did away with negative amortization of penalties for credit card. With the new draft in April this year, the RBI is clear it doesn’t want penalties to compound as interest. Not every lender does it, but now the RBI wants conformity. A penal charge is usually used to encourage credit discipline, and the RBI wants to ensure the lenders use penalties only to that extent. This is a borrower-friendly move by the RBI," said Adhil Shetty, CEO, BankBazaar.com

In case of home loans, the lenders do have the liberty to reset the credit risk component of the interest charged to the customer based on credit profile of the customer. This means that the lender can increase the rate of interest for the borrower if they default on the loans without resorting to compounding penal interest.

Here are the new changes that need to be implemented 

1. At the time of sanction, REs have to  clearly 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 or both. Subsequently, any increase in the EMI/ tenor or both on account of the above must be communicated to the borrower immediately through appropriate channels.

At the time of sanction of EMI-based floating rate personal loans, banks must take into account the repayment capacity of borrowers to ensure that adequate headroom/ margin is available for elongation of tenor and/ or increase in EMI, in the scenario of possible increase in the external benchmark rate during the tenor of the loan.

2. At the time of reset of interest rates, financial institutions  have to provide the option to the borrowers to switch over to a fixed rate as per their Board approved policy. The policy, inter alia, may also specify the number of times a borrower will be allowed to switch during the tenor of the loan.

3. The borrowers must be given the choice to opt for (i) enhancement in EMI or elongation of tenor or for a combination of both options; and, (ii) to prepay, either in part or in full, at any point during the tenor of the loan. Levy of foreclosure charges/ pre-payment penalty shall be subject to extant instructions.

4. All applicable charges for switching of loans from floating to fixed rate and any other service charges/ administrative costs incidental to the exercise of the above options have to be transparently disclosed in the sanction letter and also at the time of revision of such charges/ costs by the REs from time to time.

5. REs shall ensure that the elongation of tenor in case of floating rate loan does not result in negative amortisation. 

Amortisation is  the process of paying off debt over time in regular installments of interest and principal sufficient to repay the loan in full by its maturity date. Negative amortization means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.

6. REs  have to make accessible to the borrowers, through appropriate channels, a statement at the end of each quarter which shall at the minimum, enumerate the principal and interest recovered till date, EMI amount, number of EMIs left and annualized rate of interest / Annual Percentage Rate (APR) for the entire tenor of the loan. 

The instructions should be extended to  existing as well as new loans by December 31, 2023.

The new norms on personal loans would apply to consumer credit, education loans, loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and loans given for investment in financial assets (shares, debentures, etc.).

Home loans are where interest rates are floating

Among retail products, it’s mostly home loans where the interest rate is floating. Banks charge fixed interest rates on auto and personal loans.

Why now? 

The latest RBI mandate comes at a time when due to a sharp rise in interest rates since May 2022, most lenders opted to increase the tenor of the loan, thus leaving the amount of EMI unchanged. Home loans are mostly linked to the repo rate under the external benchmark loan rate regime.

The supervisory reviews undertaken by the RBI and the feedback from members of the public have revealed several instances of unreasonable elongation of tenor of floating rate loans by lenders without proper consent and communication to the borrowers. 

Borrowers have complained that banks normally change or reset the EMIs in an arbitrary manner and tenors are extended without informing the borrowers. Further, borrowers are not informed about the foreclosure charges. 

According to Bankbazaar, in the case of a Rs 50 lakh loan with 7 per cent interest rate in May 2022, with a 15-year EMI, the repayment period would have gone up by 90 months if the EMI amount was kept unchanged, after the repo rate was increased to 6.5 per cent from 4 per cent.

" In the last year, as the repo rate moved from 4.00% to 6.50% in just a few months, we’ve come across instances of some shocking extensions in home loan tenors. For example, someone who borrowed for 20 years suddenly sees a 30-year tenor jump. The RBI has asked for communication from lenders so that such elongations and EMI hikes due to interest rate variations do not come as a shock to the borrower. Interestingly, the RBI is also asking for options to switch to fixed rate loans, which are not typically offered by most banks," said Adhil Shetty, CEO of BankBazaar.

Implications

"The RBI's measures are intended to empower borrowers to make informed and deliberate decisions regarding their home loan repayment. These measures come after a year of heightened inflation which has caused a big spike in lending rates, which in turn have caused big spikes in loan tenors or EMIs, and sometimes, both," said Shetty.