Credit Score, Home Loan

Determination of Interest on Home Loans

09 December, 2020


Home Loan is a secured loan given by a bank against the security/hypothecation of an underlying property. In the event of failure to repay by the borrower, the bank can, subject to laws of India, attach/sell the underlying property and recover the principal amount and any outstanding interest thereon. A home loan can be availed for buying an under-construction property, resale property or even to construct a house on a vacant piece of land. Here, the lender holds the title of property as collateral until the loan is paid back in full along with the interest. Hence, this loan is secured. Home Loan is a generally a long-term loan. The tenure of loan varies somewhere between 5 and 25 years.

The bank earns a spread on the money it lends out from the money it takes in as a deposit. The net interest margin (NIM), which most banks report quarterly, represents this spread, which is simply the difference between what it earns on loans versus what it pays out as interest on deposits. This, of course, gets much more complicated given the dizzying array of credit products and interest rates used to determine the rate eventually charged for loans.

Banks use an array of factors to set interest rates. The truth is, they are looking to maximize profits, through the NIM, for their shareholders. On the flip side, consumers and businesses seek the lowest rate possible. Banks are generally free to determine the interest rate they will pay for deposits and charge for loans, but they must take the competition into account, as well as the market levels for numerous interest rates and Government policies. Interest rates determine the cost of borrowing money from banks and financial institutions. Let us understand some of the factors that bank consider while determining Rate of Interest:

MCLR (or Base Rate)

Traditionally banks used to cut interest rates when their overall cost of funds come down. For instance if a bank had Rs 1 lakh crore of deposits and the average return they paid on their deposits was around 8%, their cost of funds would be around that rate. Now if RBI brought down interest rates, the cost of overnight funds in the money market would drop immediately and the return on government bonds would also drop. What would not change immediately was the cost of fixed deposits as these would get repriced at the point of maturity. So what used to happen was that whenever RBI cut rates by 0.5% (or 50 bps) banks would stay put stating that their cost of funds have not dropped. If RBI wants its policy actions to have an immediate impact on the economy banks need to respond immediately (this process is called transmission of policy action).

To overcome this, RBI came up with a new methodolgy for calculating the benchmark lending rate for banks. This is known as the “Marginal Cost Fund Based Lending Rate”(MCLR). What this meant was that If RBI cut rates in April, a borrower who raises one year money in May would pay interest at the what it costs the bank to raise one year money in May. Earlier borrower would pay the lower rate when their MCLR came up for review.

Also banks would have different MCLR for different maturity of loans. The interesting part is that pricing of a loan is not determined by the tenure of the loan but by the cost of deposits used to provide the loan. So a bank might have bulk of its deposits in the one year category and it is these deposits that are linked to 15-year home loan. The bank would then apply one year MCLR for these loans. According to new directives, banks will have to set five benchmark lending rates for different time periods (overnight, one-month, three-month, six-month, and one-year). The base rate will be assessed according to the MCLR calculation, influenced by factors like the marginal cost of funds, tenure premium, negative carry on account of CRR (Cash Reserve Ratio) and the operating cost.

Repo Rate

Repo rate is the rate at which the Reserve Bank of India(RBI) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

The central bank takes the contrary position in the event of a fall in inflationary pressures. Repo and reverse repo rates form a part of the liquidity adjustment facility.

Reverse Repo Rate

Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market

Cash Reserve Ratio (CRR)

Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.

The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy.

CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking.

Statutory Liquidity Ratio (SLR)

Apart from Cash reserve Ratio(CRR), Every bank has to maintain a certain percentage of their “Net Demand and Time Liabilities (NDTL)” (net demand liabilities are payable on demand like saving deposits and time liabilities can only be used/withdrawn after a certain period of time) as liquid assets in the form of cash, gold etc. This ratio between liquid assets and NDTL is called the Statutory Liquidity Ratio (SLR). Maintaining the SLR restricts banks to pool more money into the economy. This, again, has an impact on lending rates.

Benchmark Prime Lending Rate (BPLR)

The Benchmark Prime Lending Rate (BPLR) has now lost relevance. But it is important to understand what it means because all retail loans were once linked to the BPLR. The BPLR is applicable to loans sanctioned before the base rate was introduced in July 2010.

The BPLR is the rate at which banks lend money to their credit-worthy customers. It was introduced to ensure transparency in the pricing of loans, according to the loan worthiness of applicants.

Let us understand this with an example.

Let us suppose that the BPLR is 8%. An applicant who has many loans running and has never delayed or defaulted on paying loan installments approaches the bank for a loan. The bank decides to grant a loan to him at an interest rate that is lower than being charged on others. The bank will lend to him at an interest rate lower than 8%(i.e. BPLR).

Many instances were reported in the past wherein banks lent at a rate as low as four per cent to big corporates/ names.

So, the RBI has capped the BPLR to a lower limit/ baseline, and this is called the base rate. No bank can lend money below the base rate.

Types of Home Loan Interest Rates

In India, two of the most predominant methods of computing interest charges on the principal amount are as below. Depending in the bank in question, you may be offered both or either of them at the time of availing the loan.

A.     Fixed Rate Home Loans:

In this system of computation, the rate remains even throughout the loan tenor. There will be no change in the interest charges since the rate remains fixed. Depending on the offer, you may be allowed to switch over to the floating rate system after completing a certain duration into the loan tenure.

Advantages: Since the rate remains fixed, you know how much interest charges you’re paying upfront. Your loan will be shielded from frequent rate fluctuations and saves money in a longer run if there is a hike in lending rates.

Disadvantage: If the standard lending rates fall, you will not benefit since the interest component remains frozen.

B.     Floating Rate Home Loans:

As the name suggests, the interest charges on your home loan is subject to the current most lending rates of the bank. The rate is linked to the latest published rate of the bank which in turn depends on multiple factors such as RBIs monetary policy and lending rate revisions, the bank’s response to the revision etc.

Advantage: The most visible perk of opting for the floating rate is that you have the advantage of being billed on the basis of the latest rate. If the rates fall, you save on interest charges.

Disadvantage: In rare scenario, if the standard rates go up, the loan has to be bear the brunt of being billed a higher rate.

Frequently asked questions

  1. How much loan am I eligible for?

Before you start the home loan process, determine your total eligibility, which will mainly depend on your repaying capacity. Your repayment capacity is based on your monthly disposable/surplus income, which, in turn, is based on factors such as total monthly income/surplus less monthly expenses, and other factors like spouse's income, assets, liabilities, stability of income, etc.

The bank has to make sure that you're able to repay the loan on time. The higher the monthly disposable income, the higher will be the loan amount you will be eligible for. Typically, a bank assumes that about 50% of your monthly disposable/surplus income is available for repayment. The tenure and interest rate will also determine the loan amount. Further, the banks generally fix an upper age limit for home loan applicants, which could impact one's eligibility.

  1. What is the maximum amount I can borrow?
    Most lenders require 10-20% of the home's purchase price as a down payment from you. It is also called 'one's own contribution' by some lenders. The rest, which is 80-90% of the property value, is financed by the lender. The total financed amount also includes registration, transfer and stamp duty charges.Even though the lender calculates a higher eligible amount, it is not necessary to borrow that amount. Even a lesser amount can be borrowed. One should try to arrange the maximum of down payment amount and less of home loan so that the interest cost is kept at minimal.
  2. Is a co-applicant necessary for a home loan?

Yes, it is (mostly) mandatory to have a co-applicant. If someone is the co-owner of the property in question, it is necessary that he/she also be the co-applicant for the home loan. If you are the sole owner of the property, any member of your immediate family can be your co-applicant.

  1. What documents are generally sought for loan approval?
    The loan application form gives a checklist of documents to be attached with it, along with a photograph. In addition to all the legal documents related to the purchase of the house, the bank will also ask you to submit your identity and residence proofs, latest salary slip (authenticated by the employer and self-attested by you) and Form 16 or income-tax return (for businessmen/self-employed) and the last 6 months bank statements/balance sheet, as applicable. Some lenders may also require collateral security like the assignment of life insurance policies, pledge of shares, national savings certificates, mutual fund units, bank deposits or other investments.
  1. What is sanctioning and disbursement of loan?
    Based on the documentary proof, the bank decides whether or not the loan can be sanctioned or provided to you. The quantum of the loan that can be sanctioned depends on this. The bank will give you a sanction letter stating the loan amount, tenure and the interest rate, among other terms of the home loan. The stated terms will be valid till the date mentioned in that letter.When the loan is actually handed over to you, it amounts to disbursement of the loan. This happens once the bank is through conducting technical, legal and valuation exercises. One may opt for a lower loan amount during disbursement against what is mentioned in the sanction letter. At the disbursal stage, you need to submit the allotment letter, photocopies of title deed, encumbrance certificate and the agreement to sell papers. The interest rate on the date of disbursement will apply, and not the one as per the sanction letter. In such a case, a new sanction letter gets prepared.
  1. How will the disbursement take place?
    The loan can be disbursed in full or in instalments, which usually does not exceed three in number. In case of an under construction property, the disbursement is in instalments based on the progress of construction, as assessed by the lender and not necessarily according to the developer's agreement. Make sure to enter into an agreement with the developer wherein the payments are linked to the construction work and not pre-defined on a time-based schedule. In case of a fully constructed property, the disbursement is made in full.

What are the interest rate options?
Home loan rates can be either fixed or flexible. In the former, the interest rate is fixed for the loan's entire tenor, while in the latter, the rate does not remain fixed.

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