Despite rate cuts, your EMIs may still not fall as much

Banks have in-built mechanism to include the cost of default in the interest rate that it charges from the borrowers as way of credit risk premium, which can be increased or decreased by the bank

HIGHLIGHTS

• RBI reduced the repo rate by 1.15% within two months. Repo rate-linked floating loans will get the quickest benefit of the cut
• SBI has increased the risk premium up to 30 basis points on its loans due to coronvirus-led hardship
• Other banks are likely to follow suit in increasing their risk premium
• Due to huge borrowing pipeline of the government, interest rates may soon start going up
• Borrower with adverse impact on income may go for EMI waiver
• Borrowers who can afford can make partial prepayment to accelerate repayment

It was a major relief for borrowers, especially home loan borrowers when the RBI went for second major reduction of interest rate by 40 basis points on May 22. Within a span of two months, the central bank has reduced the repo rate by 1.15 per cent. However, not the entire cut is likely to be passed on to many borrowers. The reason is increase in the credit risk premium that a bank charges above its cost of funds. This is the risk of default by the borrowers. We tell you how your loan will be impacted and what you should do:

Why credit risk premium is going up

Coronavirus has not only emerged as the biggest medical threat in the living memory of current generation but it has also brought economic hardships to many people. With each passing day hopes of early normalisation are giving way to a stark realisation that it will take much longer for economic activities to reach pre-corona levels. Many people have faced salary delays, pay cuts or the worst of all, a job loss. This will hugely impact the repayment capacity of many borrowers who have been affected by the current crisis either partially or in a major way. Banks have in-built mechanism to include the cost of default in the interest rate that it charges from the borrowers as way of credit risk premium, which can be increased or decreased by the bank based on its perception of economic environment.

While borrowers under MCLR and base rate regime get the transmission benefit quite late, the repo rate-linked borrowers are expected to get quickest benefit of any reduction in the repo rate. However, in the repo rate-linked home loan, there is a specific provision for credit risk premium which banks are free to increase as per their risk perception. Banks are raising their risk premium expecting rise in defaults in future.

"As per the RBI's circular, banks are independent to take their call and charge a risk premium from their borrowers. It might largely depend on how risky banks are finding their customers, what's the state of their balance sheet currently and how they foresee their business to pan out over the next two-three months. While most banks want to help disburse credit to customers, they're also being extra conservative," says Kunal Varma, CBO and Co-Founder, MoneyTap.

After SBI, many banks to follow suit

Country's biggest lender SBI has already increased its risk premium by up to 30 basis points for its repo rate-linked home loans. Many other banks are likely to follow. "The COVID-19 induced lockdown has caused widespread disruption in the economy, severely impacting the income and livelihoods of many. This has increased the credit risk for lenders, and is now being priced in by some banks through rise in the spread or credit risk premium on new loans. One should not be surprised if other banks also raise their spread or credit risk premium on their fresh loans as and when they review their lending rates," says Gaurav Aggarwal, Director & Head of Unsecured Loans, Paisabazaar.com.

Likelihood of interest rate going up

Although falling GDP and benign inflation may demand the RBI to keep cutting the interest rate, things are not that simple thanks to coronavirus induced economic hardship and the burden of subsequent economic packages announced by the RBI. The government will go for huge borrowing to support its economic package which is expected to crowd the debt market and push the rates up. "It would be very difficult to comment at this juncture on whether the interest rate regime has reached its bottom due to the expected spike in borrowings by the government. Other factors like further monetary stimulus from the RBI, inflation, fiscal deficit, foreign exchange rates, foreign capital flows, policy rate action taken by other prominent central banks, etc will also influence the interest rate curve in the economy," says Aggarwal of Paisabazaar.com

There is also a possibility that it will reduce the need for any further rate cut. "I do believe that industrial production and consumption need to pick up, and logistics and exports also need a major boost. If it starts showing signs of revival before the start of the upcoming festival season, we may not need another rate cut in the short-term," says Varma of MoneyTap. With expectation of interest rate taking U-turn and going up in the medium term, any rate cut at this point may prove to be a temporary relief.

What should you do?

Low interest rate is a great time to make partial prepayment as it accelerates your overall repayment and reduces the outstanding tenure significantly. "If borrowers can afford it, they should definitely opt for partial prepayment. But of course, not at the cost of meeting their necessary needs. They can enjoy the advantages of foregoing minimum charges on interest by doing partial prepayment," says Varma of MoneyTap.

However, if your income has been affected by the current crisis and you are facing challenges in managing your essential expenses, you may need to go for EMI waiver to preserve your cash. "Under the current scenario, preserving liquidity should be prioritised over reducing the total interest cost of borrowing. Hence, I will advise existing borrowers against making partial prepayments till there is clear signal of the reversal of the low interest rate regime. Instead, a better alternative of making prepayments is to transfer their existing loans to another lender at a lower interest rate, if available," says Aggarwal of Paisabazaar.com.

Also read: RBI moratorium on EMIs: How much extra do you have to pay for credit card dues?

Also read: Worst locusts attack in decades; crops damaged in Maharashtra, Madhya Pradesh, UP, Rajasthan