How to choose the best option among repo-linked home loans

New Delhi: From October 1, 2019, most of the banks have introduced external benchmark-linked home loan rates as mandated by the Reserve Bank of India. Transmission of policy rates has been an issue for long due to which RBI finally asked banks to move to an external benchmark. The RBI gave banks options to choose between the repo rate, 3 or 6-month treasury bills or any other benchmark market interest rate published by the FBIL as an external benchmark. But most banks have picked the repo rate as their external benchmark as it is less volatile compared to the other benchmarks suggested by the central bank.

With the new rules being implemented, now the effective interest rate on new home loans will be repo rate plus a spread as decided by the banks. Banks are required to reset the rates every three months. Components of the spread which includes operating cost can be changed once in three years. But credit risk premium, which depends on the credit score of the borrower, may get revised when the borrower’s credit score undergoes substantial change.

For example, SBI charges a spread of 265 basis points or 2.65% over the repo rate (5.15%) for a home loan up to Rs 30 lakh. In addition to this, SBI also charges 15 bps credit risk premium to those having the best credit profile (Risk Grade 1,2,3). A credit risk premium of up to 0.75% is charged depending upon factors such as source of income (salaried or nonsalaried), loan amount and internal risk grading. Women borrowers are offered 5 bps reduction on interest rates.

While the best part of SBI’s repo-linked home loan is faster transmission of RBI’s repo rate cut, borrowers face the risk of frequent increases in EMI when the rate cycle turns and RBI starts raising rates. But this should not be an issue as borrowers know that in floating-rate loans interest rates may go up or come down.

How to choose the best home loan

Now, given that most banks have adopted repo rate as the external benchmark, choosing the best home loan offer is a tricky affair. The spread charged by banks holds the key here as banks are free to decide their spread. “It is best to go with a bank that charges the narrowest spread over the repo rate. The interest rate will then be most reflective of the external benchmark rate,” a leading business daily quoted Ratan Chaudhury, Head, Home Loans at Paisabazaar.com as saying.

Apart from spread, credit risk premium can be a key determinant for selecting a particular lender. While some banks follow a transparent mechanism to charge credit risk premium other banks have not disclosed the credit risk component in their spread. While banks like SBI, Union Bank and Syndicate Bank have specified the credit risk premium, over and above the base spread, some like ICICI Bank, Axis Bank and Citibank have not.

Axis Bank on its website has stated that its total spread over repo rate is between 3.45-3.9% for salaried borrowers. Meanwhile, ICICI Bank charges a spread between 3.9-4.05% for the salaried category. But there is no break-up of spread and credit risk premium. This gives them scope to manipulate the effective interest rate charged to the borrower. Worth mentioning here is that Union Bank and Syndicate Bank have specified that they will adopt the CIBIL score to determine risk but ICICI Bank mentions that rates will vary based on “bureau score.” “Clarity is yet to emerge on the credit risk component for all banks. Borrowers will have to enquire before signing loan contracts or wait till the picture is clearer,” the publication quoted Vipul Patel, Founder, MortgageWorld as saying.

Before signing for the loan the borrower should get clarity on how the risk scoring is being arrived at. “Banks may play on credit risk premium, as internal assessments are confidential,” V.N. Kulkarni, retired banker and financial counsellor, told the publication. “The concern is that banks could use this tool to avoid passing on an RBI rate cut, citing change in borrower’s risk score,” he adds. Hence, it would be wise to enquire with your bank and ensure that factors that will constitute ‘substantial’ change in risk scoring are mentioned in the loan contract.

So borrowers should look for banks where interest rates are transparently linked to credit score that is accessable to public and easily-verifiable. Currently, there is no clarity on how banks can decide an improvement or deterioration in risk scores. But maintaining a clean credit history and high credit score will become increasingly important in the coming days. Banks consider those having CIBIL scores over 750 as credit worthy.

Should existing home loan borrowers switch to repo-linked loans

Most of the industry experts believe that borrowers will be better off under an external benchmarking regime. Experience with SBI’s RLLR scheme shows, there is a high chance of rate revision being passed on to borrowers. Banks have provisions where existing borrowers having MCLR or Base Rate-linked home loans can switch over to external benchmark-linked loans after paying administrative or legal charges. The final rate and other terms and conditions will be similar to those for new borrowers in the same category. For example, SBI charged 0.25% of outstanding principal amount as fees to switch from MCLR-linked loan to RLLR linked loan. But other banks have not yet released their schedule of charges for repo-linked home loans.

So, before switching to your existing bank’s repo-linked scheme, carry out a cost-benefit analysis. To determine whether you should shift to your existing lender’s external benchmark linked loan or to a new bank, evaluate the difference between the two rates. “Make the switch if the gap is at least 35 bps,” says Patel.