File photo: A Reserve Bank of India (RBI) logo is seen inside its headquarters in Mumbai, India, April 6, 2023.
| Photo Credit: Reuters

The story so far: On August 18, apex banking regulator the Reserve Bank of India (RBI) issued guidelines enabling a borrower to transition from a floating interest rate-based loan to one with a fixed interest rate.

According to RBI, the endeavour was to address borrowers’ grievances pertaining to elongation of loan tenure and/or increase in the EMI amount in the event of an increase in the benchmark interest rate. A lack of proper communication along with the absence of consent too formed part of the concerns.

The provisions would be extended to existing as well as new loans by the end of the current calendar year. 

What exactly has the RBI instructed?  

As stated above, the apex banking regulator has given borrowers the option to switch over to a fixed (interest) rate mechanism for their loans from floating rates. This would be based on a board-approved policy drafted by the lending entity. The policy must also specify the number of times such a switch would be allowing during the tenure.

The lender must also transparently communicate to the borrower all relevant charges alongside service charges or administrative costs associated with the transition. 

The responsibility would rest with the lender to communicate clearly, at the time of loan sanction, the impact emanating from the change in regime (floating to fixed), such as the change in EMI and/or tenure of the loan or both. Additionally, the borrower would now also have the option to choose between enhancement of the EMI or elongation of the tenure or a combination of both. S/he might also opt to prepay the loan, either in part or full, at any point during the tenure. This would, however, still invite foreclosure charges or pre-payment penalty.

 Further, the regulator has sought that lending entities provide borrowers, through appropriate channels, a statement at the end of each quarter enumerating the principal and interest recovered till date, EMI amount, number of EMIs left and annualised rate of interest/ Annual Percentage Rate (APR) — for the entire tenure of the loan. RBI has asked for the statement to be “simple and easily understood by the borrower”. 

The instructions would apply to all equated instalment-based loans of different periodicities. albeit with certain changes based on the nature of the loan. 

What is the difference between a fixed and floating interest rate?  

Fixed interest rates are those that do not change during the tenure of the loan. On the other hand, floating interest rates are subject to market dynamics and the base rate — therefore, the risk differentiation. As also contended by several lending entities, floating interest rates are generally lower than the fixed interest rates. For example, if the floating interest rates for home loans is 10.5%, the fixed interest rate would be 12%. 

Lenders argue that even if the floating interest rate were to rise by up to 2.5 percentage points, the borrower would be able to save more money when it is below the fixed rate. It has been widely argued that their preference for the floating rate-based regime is to better adjust their positions as per the evolving market dynamics. Should the benchmark rates drop significantly, the advantages are transmitted onto the borrower’s savings pool, but the opposite also holds true in a rising benchmark rate regime. Also noteworthy is the fact that floating interest rate loans do not draw any prepayment penalty— unlike fixed rate loans. 

However, the fixed rate-based regime endows a borrower with greater certainty and security. This also helps in better planning and structuring of individual budgets.

Thus, prospective borrowers should note broader evolving economic dynamics and accordingly decide the tenure they seek. 

In a largely similar context, in 2010, V.K. Sharma, then Executive Director at the RBI, said at a conclave that lenders may argue that housing loan borrowers would prefer a floating-rate loan to a fixed rate. This is where RBI’s guidelines relating to “customer appropriateness and financial literacy and credit counselling” enjoined upon banks come in, he pointed out.

“This is because typically an unsophisticated, and uninitiated, borrower may be driven largely by the prevailing lower short-term interest rates, almost completely oblivious to the potentially higher interest rates over such a long-time horizon, as say, 10 years or more,” he stated. 

What does the regular state about assessment of repayment capacity?  

RBI stated in the circular that lending entities are required to consider the repayment capacity of the prospective borrower. This is to allow borrowers adequate (or optimum) headroom/margin for elongation of tenure and/or increase in EMI.  

About parameters for assessment, Governor Shaktikanta Das, too, had earlier stated that banks would have to consider the payment capacity of the borrower and how longpayment capacity would last (the age factor). He cautioned that it would be necessary to “avoid unduly long elongation which sometime may going forward camouflage the underlying stress in a particular loan.” The extension, he stated, must be for a “reasonable period”. 

“It is a commercial decision that the banks have to take. We are just providing some broad guidelines,” he informed.  

Indian Rupee notes are seen in this picture illustration taken in Mumbai June 12, 2013. File. (For Representational purpose only)
| Photo Credit: Reuters

The rupee depreciated by 8 paise to 82.74 against the US dollar in early trade on Friday, tracking a firm dollar against major rivals overseas.

Analysts said, weak sentiment in the domestic equity market and elevated level of crude prices nearing USD 87 per barrel also weighed on the domestic unit.

On Thursday, the Reserve Bank of India in its bi-monthly monetary policy review decided to keep key interest rate unchanged, but hinted at tighter policy if food prices drive inflation higher.

The American currency regained after US consumer price inflation showed moderation in July, raising hopes that the US Federal Reserve would pause rate hike.

At the interbank foreign exchange market, the local unit opened at 82.75 against the US dollar and moved in a narrow range of 82.73 to 82.76. It later traded at 82.74 against the greenback, registering a fall of 8 paise from its previous close.

On Thursday, the rupee rebounded 19 paise to close at 82.66 against the US dollar after the RBI asked banks to set aside a larger part of incremental deposits under the cash reserve ratio (CRR) as part of measures to take out excess liquidity from the banking system.

Meanwhile, the dollar index, which gauges the greenback’s strength against a basket of six currencies, rose 0.05% to 102.57.

Global oil benchmark Brent crude was trading 0.02% lower at USD 86.38 per barrel.

In the domestic equity market, the 30-share BSE Sensex was trading 229.33 points or 0.35 per cent lower at 65,458.85. The broader NSE Nifty declined 76.05 points or 0.39% to 19,467.05.

Foreign Institutional Investors (FIIs) were net buyers in the capital markets on Thursday as they purchased shares worth Rs 331.22 crore, according to exchange data.