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Factors that influence your loan rate

Abitha Deepak, BankBazaar.com | January 14, 2009

Money lent by banks and financial institutions for various purposes come with a cost, which is known as the loan rate or the interest rate at which the loan is lent.

In recent times there has been a spate of CRR (cash reserve ratio) and repo rate cuts following which interest rates on home loans have been slashed. This has been a welcome relief for potential, first-time home buyers who have been waiting for this to happen for a long time.

So what do CRR, repo rate, reverse repo rate, SLR, et cetera mean in the context of your home loan interest rate? Well, all these factors have a direct impact on the PLR (prime lending rate), which correspondingly increases or decreases the interest rates of loans.

Let's take a quick look at what all these terms mean to see how they affect the loan interest rates.

Prime Lending Rate (PLR)

This is the benchmark interest rate on the basis of which financial institutions decide the interest rates on the various loan products. For example, a bank might say a loan interest rate will always be 0.5% above the PLR. This means, if the PLR increases or decreases by a certain amount, the interest rates charged on the floating rate loans offered by the bank also increase or decrease by the same amount.

Cash Reserve Ratio (CRR)

It is the percentage of cash deposits that banks need to keep with the Reserve Bank of India [Get Quote] on an everyday basis. Increasing the CRR also means banks have lesser money to lend. RBI adjusts the CRR to change the amount of liquidity in the financial system, which helps to keep the inflation within reasonable limits.

Also, when CRR is increased, the interest rates also increase as the amount of liquidity in the financial system decreases. RBI has made frequent CRR cuts in the recent past to inject liquidity into the financial system. This is expected to impact the interest rates bunched with other favourable aspects for home loan applicants.

Repo Rate

This is the interest rate at which RBI lends money to the banks whenever they need to borrow funds from RBI. When the repo rate decreases its good news for the banks as they can avail more funds at a lower interest rate and vice versa.

Reverse Repo Rate

This means just the opposite! Here, RBI borrows funds from the banks and when the Reverse Repo Rate increases banks are very happy to lend money to RBI because of the attractive interest rates RBI offers to obtain the loans.

SLR (Statutory Liquidity Ratio) Rate

Every commercial bank needs to maintain a certain amount of funds in some form -- which includes cash, gold, government bonds, etc -- before they can provide credit to its customers. This measure helps RBI have control over the bank's credit expansion, keeping it realistic.

The collective impact of all these rates influence the liquidity in the financial system and lead to an increase or decrease in PLR, which in turn affects loan lending rates.

Benchmark Prime Lending Rate (BPLR)

A while ago, those who had been subjected to steep interest hikes in the past eagerly looked forward to see the interest rate cuts from their banks. Some banks were planning to pass on the benefits to the existing customers while some others were cutting down interest rates only for their new customers.

What were the factors that came into play here? How are banks able to give the lower rates only to new customers while keeping older customers at a higher rate? Well, banks have something called the benchmark prime lending rate, which is a reference interest rate that is used as a benchmark to determine the interest rate that is passed on to the customer.

The interest rate that is finally passed on to the customer is X% plus or minus this benchmark prime lending rate.

This X% is termed a 'spread', and is left to the discretion of the bank to set and depends on the other factors involved in loan eligibility like the credit profile of the loan seeker, for instance.

According to RBI regulations, banks are required to make changes in existing loans except fixed interest rate home loans, when they change their existing BPLR.

However, since banks are given the freedom to set the spread from the BPLR at whatever value they choose for new customers, they are able to provide attractive rates to new customers while continuing to charge a much higher interest rate for older customers.

For example, suppose Suresh took a home loan at a floating rate of BPLR minus 2% at a time when the bank's BPLR was 9%. The floating rate of 7% that he received was attractive and it seemed to be the right decision to choose this loan.

Over time the BPLR of the bank increased to 15% and Suresh's floating rate became13%. However, Suresh's bank is now offering a floating rate of BPLR minus 3.5% to new customers, which means that new customers are paying a rate of 11.5%, while Suresh is stuck with an interest rate of 13%.

The irony of this situation is that Suresh signed up for a floating rate knowing that his rate would increase or decrease according to market conditions, not realising that his bank has the power to not share the benefit of a falling rate with him.

From the bank's perspective this is profitable, as they will end up making more money off Suresh's loan if they charge him a higher interest rate.

Banks have various clauses in the loan agreement that keep the best interests of the lender in mind as the money outflow from banks, even on an everyday basis is enormous. As shown in the example above, the clause that dictates banks can opt to choose the 'spread' from the BPLR is the catch that loan consumers need to be aware of.

However, after what seemed like a long wait banks have started to effect changes in their BPLR in the wake of the current spate of repo and CRR rate cuts.

Every bank has a cycle to bring the benefit of this change to the existing customers. According to bank policies, this change or floating interest can come into effect on a quarterly or yearly basis or with immediate effect.

The author is head of content & research at BankBazaar.com.

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