Cut in base rate better than spread reduction
Since the beginning of this year, banks have been lowering interest rates for home loan borrowers. Union Bank of India (UBI) set the mood for a rate cut in January with a 10-basis-point (bp) reduction in the base rate (100 basis points = one percentage point). After the Reserve Bank of India cut the benchmark lending rate last month, many banks (Punjab National Bank, Central Bank of India and ICICI Bank) reduced their base rates by up to 25 bps. A bank can’t lend below its base rate.
Some others, like IDBI Bank in March and UBI last week, lowered interest rates on home loans but did not cut the base rate. How? The interest levied on a home loan is a combination of a bank's base rate and a spread or margin charged over this. When banks cut the loan rate without changing the base rate, they bring down the spread.
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The spread is typically decided when you take a loan. A number of factors go into deciding it, including your credit profile, employer, income level, loan-to-salary ratio and so on. If any of these do not change substantially, the spread should be unchanged. It differs across borrowers.
|JUDGING A CUT|
|* Experts advise caution in reacting when banks cut rates without cutting the base rate|
|* There’s no norm on calculating spreads over the base rate|
|* Spreads can be tweaked at any time and are a grey area|
|* Base rate, being market-linked, is more transparent for borrowers|
|* Base rate is reviewed every three months but does not change often|
|* Many have cut lending rates keeping base rates intact|
Mumbai-based Aruna Jayashankar (name changed on request), who has a home loan account with UBI questioned it on which of the two rate reductions was more beneficial for her. The reply was, “The end result is the same."
Adhil Shetty of BankBazaar.com says reduction in a bank’s spread does not happen often. “Cut in spread is non-standard and needs to be reviewed with caution. Cut in base rate is far more transparent for passing on benefits to borrowers," he says.
Typically, a cut in spread is for new borrowers and the existing ones are benefited only if the base rate is changed. But banks can also decide to pass on a spread cut to existing borrowers, like UBI did last week, to “all new and existing floating rate customers". It reduced home loan rates by 50-150 bps across various tenures. Loans of up to Rs 30 lakh will come at 10.5 per cent or the base rate. Earlier, these were levied 50 bps more. Loans between Rs 30 lakh and Rs 75 lakh, would be charged at 25 bps over the base rate. Loans between Rs 75 lakh and Rs 5 crore would be levied 50 bps over the base rate.
Given that the base rate is market-linked, a revision there is more beneficial and transparent. Banks review their base rates every quarter. As market conditions do not change drastically every couple of months, it does not change often and to that extent is a more permanent component of the lending rate, explain bankers. So, a cut in the base rate is likely to stay longer for a borrower.
That may not be true for a cut in spread. “Spread is a way of earning for banks and there is no norm on when and how it can be changed. Even if a bank cuts the spread today, there are chances it may restore this when it cuts the base rate next time," says a senior official with Oriental Bank of Commerce. Assume you are repaying at 10 per cent today and with a cut in lending rate or spread, your rate is revised to 9.5 per cent. It may happen that when the bank cuts its base rate by 50 bps, your rate continues at 9.5 per cent, as your spread has been increased by 50 bps.
However, a senior banker at a foreign lender argues that a cut in spread is more beneficial, as banks do not generally restore or increase the spread. “Spreads are mostly constant for each customer and, hence, a cut in it better, as it benefits banks to have a higher spread," he says.