RBI allows switch from ‘floating to fixed rate’ regime

The Reserve Bank of India (RBI) asked all regulated entities (REs), including banks and NBFCs, to give personal loan borrowers an option to switch over from a floating rate to a fixed rate regime at the time of resetting interest rates.

• When a customer takes a loan, the interest rate reset clause in the loan agreement allows the lender to review the interest rate after a certain period, as per the occurrence of a scheduled reset date of the loan.
• The reset rate is the new interest rate that a borrower must pay effective from the scheduled reset date.
• EMI of a floating rate loan changes with periodical changes in reset interest rates.
• These rates and the calculation are not uniform for all the banks as the cost of funds differs from banks.

Changes made by RBI:

The RBI asked banks to implement the following regulations:

• For Regulated entities (RE) :
  • At the time of sanction, REs will have to clearly communicate to the borrowers about the possible impact of a change in benchmark interest rate on the loan leading to changes in EMI and/or tenor or both.
  • Any increase in the EMI/ tenor or both will have to be communicated to the borrower immediately through appropriate channels.
  • At the time of reset of interest rates, REs will have to give the option to borrowers to switch over to a fixed rate as per their board-approved policy.
  • The policy will also specify the number of times a borrower will be allowed to switch during the tenor of the loan.
  • REs will have to disclose all applicable charges for switching loans from floating to fixed rate and any other service charges/ administrative costs in the sanction letter and also at the time of revision of charges or costs from time to time.
• For EMI or Elongation of tenor:
  • The borrowers will also be given the choice to opt for enhancement in EMI or elongation of tenor or for a combination of both options, and to prepay, either in part or in full, at any point during the tenor of the loan, with foreclosure charges.
  • The RBI said REs will have to ensure that these instructions are extended to the existing as well as new loans by December 31, 2023.

Why has RBI issued new regulations?

• RBI's Supervisory Reviews: The Reserve Bank of India (RBI) has conducted supervisory reviews and received feedback from the public.
• Unreasonable Tenor Elongation: Instances of banks significantly extending tenors of floating rate loans without proper borrower consent and communication have been identified.
• Interest Rate Changes: Banks can alter interest rates by adjusting the internal benchmark rate and spread during the loan term, potentially harming borrowers' interests and monetary transmission.
• Arbitrary EMI Resets: Borrowers complain of banks arbitrarily resetting Equated Monthly Installments (EMIs) and extending tenors without adequate notification.
• Hidden Foreclosure Charges: Borrowers are often unaware of foreclosure charges, adding to borrower dissatisfaction.
• Stress Concealment: RBI notes that prolonged tenor elongation may obscure underlying stress in banks' financial health.
• Refinancing Challenges: While theoretically possible, refinancing floating rate loans across different banks with distinct internal benchmarks is complex due to varying benchmark adjustment methods.
• Limited Borrower Options: Borrowers might feel compelled to stay with their original bank, paying higher charges, as refinancing is often impractical due to benchmark disparities.

Possible impacts:

• Interest rate of borrowers: Banks can change the interest rate by changing the internal benchmark rate and the spread during the term of the loan which could harm the interest of the borrower and also impair monetary transmission.

Benefits of Fixed rate regime:

• For borrowers:
  • Protection from Rate Hikes: Shifting to a fixed rate provides protection against potential future increases in interest rates. This can be particularly beneficial if interest rates are expected to rise in the near future.
  • Budgeting and Financial Planning: Fixed payments make it easier for borrowers to budget and plan their finances since they know exactly how much they need to allocate for their loan payments.
  • Potential Cost: Fixed interest rates tend to be initially higher than prevailing floating rates. Borrowers opting for a fixed rate might end up paying more initially compared to what they would have paid with a floating rate if rates remain relatively stable or decrease.
• For lenders:
  • Interest Rate Risk Mitigation: Lenders are less exposed to interest rate risks when borrowers opt for fixed rates. They can better manage their own interest rate risk since they know the interest income they'll receive remains constant.
  • Lending Profitability: Fixed-rate loans typically come with higher initial interest rates compared to floating-rate loans. This can lead to increased lending profitability for lenders, especially if rates remain stable or decline.
  • Potential Lower Loan Demand: Higher initial fixed rates might deter some potential borrowers who are attracted to lower initial payments offered by floating rates.
  • Limited Flexibility: Lenders might have less flexibility in adjusting loan terms for borrowers with fixed-rate loans, as the interest rate remains constant regardless of market conditions.