From July 1, the banking sector moved into this new interest rate regime.
Anew interest rate regime kicked off when the country moved to the Reserve Bank of India (RBI) mandated system of base rate, which is likely to be a more objective interest rate benchmark than the one currently followed - benchmark prime lending rate (BPLR) system. It is also believed that compared to the BPLR system, the base rate regime will bring in more transparency in fixing a rate in the banking system.
In the new regime, interest rates will be benchmarked to base rates with all the lending rates linked to the respective base rates of each bank. This is with effect from July 1. The interest rates on your loan have been fixed against the benchmark rate. Assuming that your present interest rate is nine percent and the bank has fixed the base rate at 7.5 percent, your interest rate will be termed as 1.5 percentage points higher than the base rate. Banks did not hike the mortgage rates, instead, they just pegged them as against their respective base rates. In fact, the new system is likely to help home loan borrowers in a big way.
In the earlier regime, the mechanism of fixing the BPLR was not very transparent. Banks used to fix them on the basis of their capacity and willingness to lower the lending rates to the existing customers. For the new customers, they used to bring down the offer rate by increasing the discount to the BPLR.
For example, if a bank has fixed the BPLR at 12 percent and had given loan to a borrower at three percentage points discount to the BPLR, it means it has given a loan at nine percent to the borrower. Unless the BPLR is changed, the borrower will continue to pay nine percent interest rate. Now, when the interest rate in the market goes up, banks increase the BPLR to pass on the rise in the cost of the funds to the existing borrowers.
Suppose the BPLR increases from 12 to 12.5 percent, the interest rates of the existing borrower will increase to 9.5 percent from nine percent. But when the interest rates in the market fall, banks should reduce the BPLR to pass on the benefit of lower interest rates to existing customers also. But it has been seen in the past that banks do not cut the BPLR. So, existing customers continue to pay the higher interest rates.
But, for new customers, they increase the discount to BPLR. So, to pass on the benefit to new customers, banks used to increase the discount. In this example, if the earlier discount was three percent, they used to increase it to 3.5 or four percent. So, the new effective rates used to become 8.5 percent with 3.5 percent discount and eight percent in the case of four percent discount to the BPLR. But, the system used to put existing borrowers at a disadvantage.
In the new system, however, banks will have to fix the base rate on the basis of the cost of funds, which is known to the regulators. The base rate is arrived at by taking into consideration a bank's cost of deposits, its profitability in the previous fiscal year, its administrative costs etc, with the cost of deposits having the highest weight. They will have to visit their base rate every quarter.
In fact, when the rates are rising, they cannot change it immediately but will have to wait for the new quarter to start. This system has already benefited existing customers. Most banks have announced the base rates on July 1 and 2. Just after their announcements, the RBI increased the policy rates to make the funds costly. But, now banks cannot change the base rate for the next three months. So, the existing customers will continue to pay the present rate.
Suppose your home loan is at nine percent and the base rate of your bank is 7.5 percent. This means the bank has fixed your rate 1.5 percent higher than the base rate. Now, as the banks can't change the base rate, you will continue to pay nine percent. But as the cost of fund has gone up, banks might decide to charge higher rates at 9.5 percent from new borrowers by raising the premium over the base rate from the existing level of 1.5 to two percent.
