Home loan borrowers may wonder why they should keep up with the Reserve Bank of India’s monetary policy announcements, as they often assume that the interest rate on their home loans is set solely by the lender of their choice. It, however, is not entirely true.

The apex bank dictates that all commercial banks who engage in the retail term loan lending business must link their interest rates to any of the external benchmarks approved and listed by them, including the RBI repo rate. Housing Finance Companies and Non-Banking Finance Companies on the other hand, are not made to comply to this rule as yet, allowing them to offer home loans linked to an external benchmark, such as the repo rate, as a competitive market offering.

Before we delve further into the subject, let us first understand what is repo rate, and the role it plays in the RBI’s monetary policy.

RBI Repo Rate: Definition

The RBI repo rate is the rate at which commercial banks and lenders borrow funds from the central bank, short for Repurchasing Option. Such borrowers also have to provide security in the form of treasury bills or gold assets to the Reserve Bank of India as collateral for the loan sanction. Readers should note that as of 8 June 2022, the RBI repo rate stands at 4.90%.

RBI Repo Rate: Function

The repo rate’s primary function is to make credit available to needy lenders in the Indian market, but it does not stop at just that. The monetary policy tool is also crucial in controlling inflation in the economy. To curb high inflation, the central bank can hike up the rate to discourage lender borrowing, thereby limiting the liquidity in the market, and curtailing its purchasing power. Similarly, to drum up more liquidity in the market, the repo rate is reduced – allowing lenders to borrow at nominal rates and sanctioning more loans to interested customers and borrowers.

Bearing this in mind, home loan applicants borrowing from reputed HFCs and NBFCs have an additional choice to make – to link their home loan interest rates to the RBI repo rate or not. To make this decision, one must be aware of all the benefits of linking their home loans to an external benchmark and the considerations to keep in mind before applying for one.

Benefits of External Benchmark Linked Home Loans

Aspiring home loan borrowers can choose to link their home loans to an external benchmark, such as the RBI repo rate and benefit from the following features.

Ensures Transparency for Borrowers

Borrowers who link their home loan interest rates to the RBI repo rate enjoy a degree of transparency in regard to how the interest rate can increase or decrease. Any change in the repo rate makes an impact on the home loan interest rate, as it is directly regulated by the repo rate. If you want to link your home loan interest rate to the RBI repo rate, here is what your interest rate will be composed of:

• External Benchmark: This portion of the interest rate is linked to any external benchmark mandated by the RBI, such as the repo rate and any movement in the benchmark reflects in the individual home loan interest rate. Borrowers can monitor external factors impacting the cost of their home loans with ease, and benefit from rate reductions with clear transparency. One must bear in mind that just as they enjoy rate reductions, they can also pay a higher rate of interest should the repo rate be increased.
• The Internal Spread: Along with the external benchmark, lenders build in an additional ‘spread’ component before determining the final home loan interest rate they can offer. While the external benchmark is decided on a national level, the spread is internal to the organisations’ home loan eligibility criteria and lending policies. The spread component of the home loan interest rate is calculated based on the individual’s profile, assessing the risks attached to their loan application.

Chances of Higher Savings

By availing of an external benchmark linked home loan, borrowers rely not only on the lender’s internal lending rate policies but on macro-economic factors as well. It could lead to a reduced cost of borrowing home loans, as a part of the interest rate is regulated by the Reserve Bank of India. What’s more, borrowers can enjoy revised home loan interest rates almost immediately, as any change in the repo rate leads to a near-immediate resetting of home loan interest rates (as per the lender and the RBI’s policy). 

Home loan research should also include an analysis of what home loan interest rate is best suited for you – external benchmark linked home loans or home loans linked to the lender’s internal floating reference rates. Depending on your financial standing and future aspirations, choose the one that holds the most chances of ensuring a reduced cost of borrowing.