Base Rate: Boon for borrower

From July 1,the banking sector moved into a new interest rate regime called Base Rate,which is believed to be a huge improvement on the earlier BPLR system.Prabhakar Sinha outlines how it can benefit home loan borrowers

Anew interest rate regime kicked off last Thursday when the country moved to the 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 the 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 from Thursday,July 1.The interest rates on your loan have been fixed against the benchmark rate.Assuming that your present interest rate is 9% and the bank has fixed the base rate at 7.5%,your interest rate will be termed as 1.5 percentage points higher than the base rate.Banks have not hiked 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% and has given loan to a borrower at 3 percentage points discount to the BPLR,it means it has given a loan at 9% to the borrower.Unless the BPLR is changed,the borrower will continue to pay 9% interest rate.Now,when the interest rate in the market goes up,banks increase BPLR to pass rise in the cost of the funds to the existing borrowers.Suppose the BPLR increases from 12% to 12.5%,the interest rates of the existing borrower will increase to 9.5% from 9%.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 3%,they used to increase it to 3.5% or to 4%.So,the new effective rates used to become 8.5% with 3.5% discount and 8% in the case of 4% discount to the BPLR.But,the system used to put old 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 banks cost of deposits,its profitability of the previous fiscal year,its administrative costs,etc,with the cost of deposits having the most 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,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.