More clarity on EMIs, tenor: Borrowers can soon switch between floating, fixed loans

The Reserve Bank of India (RBI) has asked the banks to be more transparent in resetting  interest rate and EMIs of floating rate home loans under the external benchmark based lending rate (EBLR) mechanism.

RBI has also  asked the banks to have a more transparent framework in pricing their floating rate interest rate. 

The central bank has also asked the lender to offer the borrowers under EBLR regime an option to switch to fixed rate home loan whenever they want.

 Home loans come at either floating interest rates or fixed interest rates. The decision to choose one over the other is vital for a borrower as that affects the EMI repayment rate plan. 

The proposed framework will primarily focus on enhancing communication with borrowers regarding any changes in loan schedules and adjustments to equated monthly instalments (EMIs)

 

What is the difference between floating interest rates and fixed interest rates?

"Floating interest rates, as the name suggests means that the rate of interest paid by the borrower is directly related to the current financial environment. If the bank interest rate falls, then the interest rate of the EMI too will fall and if the interest rate goes up the EMI rate too will move up," explains Bank of Baroda.

Fixed interest rates on housing loans refer to an unchanged rate of interest irrespective of the change in repo rates. The rate of interest is decided at the time when the loan is approved and sanctioned by the bank. This loan amount is unaffected by inflation rates. Borrowers who choose fixed home loan interest rate on long-term housing loans do so as they feel comfortable with assured and consistent monthly payments of EMIs.

Fixed rates interest rates come at higher price than floating interest rates.  It is ideal for those who are unsure of the market standing in long term loans and prefer to repay loans at a fixed amount.      

"Floating interest rates come with a benchmark rate stated by the lender. These are adjustable as they are subject to market fluctuation and the floating home loan interest rate varies accordingly. The lender defines a calendar period to reset the loan's floating interest rates. It could be the loan anniversary date or any quarterly or half-yearly or monthly resetting cycle. The period is reviewed and if any fluctuation is recorded in the market rate, the interest rate is reset," as per Bank of Baroda.

 The reset directly impacts the tenure date when the interest rate registers a change. With the increase of the market rate, the loan tenure is extended and decreased if the market rate falls. The EMI is not altered as that can have an inverse effect on the cash flow and prove difficult for the borrower. However, the borrower can also raise the EMI instead of the tenure whichever is better.

Floating interest rates are generally favourable when you expect market interest rates to fall. If you are choosing the loan tenure as less than five years, choosing a lower rate will be better with a lower floating home loan interest rate.

What is the current framework?

Since October 2019, the RBI said that all floating rate-based loans are required to be linked to an external benchmark. Initially, when the external benchmark system was introduced, the RBI allowed banks to reset the EMI once three months. Currently,  loan seekers can switch from floating to fixed interest rates and vice versa but have to pay a nominal conversion fee between 0.50 per cent to 2 per cent of the total home loan amount.

Why change it? 

In light of supervisory reviews conducted by the RBI and input received from the public, instances of lenders prolonging the tenor of floating-rate loans without proper consent and communication have been identified. To address this concern, the RBI intends to establish a comprehensive conduct framework that all regulated entities must adhere to. This framework aims to rectify the challenges faced by borrowers.

What has the RBI now said?

RBI Governor Shaktikanta Das said under the framework, to be put in place shortly, the lenders will have to clearly communicate with the borrowers about tenor and EMI.

"The framework will require Regulated Entities to (i) clearly communicate with borrowers for resetting the tenor and/or EMI; (ii) provide options for switching to fixed-rate loans or foreclosure of loans; (iii) disclose various charges incidental to the exercise of the options; and (iv) ensure proper communication of key information to borrowers."

The RBI also said the new framework will allow borrowers to switch to fixed interest rate from floating interest rates.

This would provide relief to borrowers of home, auto and other loans reeling under the impact of high interest rate.

What this move means?

The background to the regulatory announcement on EMIs is that the RBI has been over a long time pushing for transparency and communication. It has at various stages insisted that regulated entities such as banks communicate clearly to consumers, especially on charges and key facts. 

" 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.

"Like in case of interest rate hikes, lenders usually increase the loan tenure of existing home loan borrowers, with the EMI remaining the same. In this case, many consumers remain unaware of the higher interest cost incurred due to tenure extension. A mandatory consent from the borrower before the tenure increase would help borrowers take an informed decision while choosing between the EMI increase option and tenure increase option," said Naveen Kukreja, Co-Founder and CEO, Paisabazaar.