The truth about home loans

A floating rate is not so floating as it is fixed. But the reverse is not true as the fixed rate is always fixed. So floating rate is both fixed and floating, depending on the whims of the lender.

No, this is not a riddle. All the same, it's a concept anyone who wants to take a home loan needs to understand.

Rahul Roy, K Tamankar and Dipti Swain (all names changed) have taken floating rate home loans from the State Bank of India, the country's largest commercial bank.

Theoretically, with every home loan rate cut, customers with floating rates should get the benefit of lower interest rates (just as much as they would have to pay more if interest rates go up) in contrast to those who have opted for fixed rate loans.

But the reality is different.

Roy is paying 10.75 per cent interest, Tamankar 10.25 per cent and Swain 9.5 per cent. The maturity profiles of all the loans are the same -- 15 years.

Similarly, floating rate customers of Housing Development Finance Corporation who took loans before February this year are paying an interest rate of 10 per cent.

But those who are taking loans now (after February 5) will need to pay 9.75 per cent only. This is despite the fact that all of them are floating rate customers.

Welcome to the chaos in the Indian mortgage market which is growing at break-neck speed over the past two years.

The leader HDFC has been growing at over 40 per cent every year on the retail loan turf. Other housing finance companies like LIC Housing, GIC Housing, Dewan Housing are also growing.

But the spotlight is on the new entrants: the commercial banks.

Led by the SBI and ICICI Bank, all of them are disbursing housing loans as if there is no tomorrow. With corporations still shying away from lifting bank credit, this is the surest way to grow.

The additional incentive to build a big housing loan portfolio is the capital concession given by the Reserve Bank of India.

The risk weight on home loans is 50 per cent. That is, for every Rs 100 worth of corporate loans banks need capital of Rs 9 (which means, the risk weight is 100 per cent) but for housing loans the requirement is only Rs 4.5.

But in their over-enthusiasm to corner a larger chunk of the market, the players are adding to the chaos and confusion.

First, let's take a look at fixed and floating rate controversy. Once a customer opts for a fixed loan, he locks himself for a rate which will be unchanged for the entire tenure of the loan unless he wishes to shift from floating to fixed (by paying a fee).

For floating rate loans, the rates can go up or down, depending on the overall interest rate scenario. Normally, this is linked to a benchmark rate and moves with that rate. By opting for a floating rate loan, customers, in effect, take a call on the interest rate outlook. If the outlook is soft, an increasing number of borrowers go for the floating rate which has been happening now.

If this is the case, why are there so many floating rates floating in SBI or ICICI Bank? Or, for that matter, why are there two floating rates in HDFC?

Let's take the case of SBI first. Its home loan rates are linked to benchmark medium term prime rate (MTPR) which is 11.25 per cent.

Last year, it offered long-term home loans (above 15 years) at 50 basis points (one basis point is one hundredth of a percentage point) lower than its MTPR at 10.75 per cent.

Subsequently, it cut the home loan rate to 10.25 per cent. This was done without changing the benchmark rate but by widening the spread below MTPR from 50 basis points to one percentage point.

This month again the SBI brought down the home loan rate to 9.5 per cent. This time, too, it did not change the benchmark rate but widened the spread further to 175 basis points.

The net result of this? The SBI now has three sets of floating rate customers and the old customers are not getting the benefit of the rate cuts. This is against the spirit of floating rate loans.

HDFC's benchmark rate is Retail Prime Lending Rate (RPLR). Between January and November 2002, HDFC cut its rates four times and each time its floating rate customers gained.

But this month when it lowered the home loan rate yet again, it did so by cutting its benchmark rate by 25 basis points as well as introducing a new rate by offering a floating rate at 25 basis points lower than RPLR.

So HDFC has two sets of floating rate customers now. One set pays 10 per cent (which is also HDFC's RPLR) and other 9.75 per cent. ICICI Bank's home loans too is not always linked to the benchmark rate.

In other words, floating rate loans for all practical purposes have been turned into fixed rate loans in a low interest rate regime.

The point is that if interest rates increase borrowers will be forced to cough up more money since banks  will then certainly increase their benchmark rates which will affect all customers.

The main reason for this anomaly is the absence of a separate benchmark for home loans in the banking system. The prime lending rate is essentially meant for industrial loans which carry a 100 per cent risk weight.

It cannot be tinkered with every now and then while home loan rates are changing once every three months or so.

Since the SBI or ICICI Bank cannot afford to bring down their PLR every three months, there must be a separate benchmark rate for the home loans -- HPLR.

Once the banks adopt the segmented PLR approach, they will not be required to widen the spread below the benchmark rate to bring down the home loan rates.

Instead, they can reduce the HPLR right away and make the floating rate loans truly beneficial for all.

But this alone will not bring in sanity to the mortgage market. There are others issues that need to be addressed on a war footing.

For instance, different players have different timeframes for implementing the floating rates and the waiting period for getting the benefit for the rate cut ranges between one and six months.

Then, there is the issue of interest rate calculation. There are players who go by yearly rest (here the borrower pays interest on the principal outstanding in the beginning of the year and it does not come down with every instalment payment), monthly rest and even daily rest.

Finally, one needs to read the fine print of the loan documents with a microscope. The loan document of one new private bank says the bank can call back the loan if it decides to withdraw from this segment for regulatory reasons or internal business decisions.

Another big private bank, which has been heavily into home loan disbursals, outlines in its loan documents that even the interest rate on fixed rate loans can be altered at the sole discretion of the lender.

If the rate is raised, the borrower can prepay the loan in fulfilling all terms and conditions (read after paying penal interest rate).

A big commercial bank that offers quarterly rest, calculates the interest rates on the highest monthly balance of the principal amount.

In other words, if a borrower with a Rs 10 lakh (Rs 1 million) outstanding on a particular month makes a Rs 3 lakh (Rs 300,000) lump sum prepayment to bring down the interest cost, he will still have to pay interest on Rs 10 lakh.

Uniform loan documentation and transparent interest rate structure are the two keys to the growth of the mortgages market. If this is not done, aggressive players may end up killing the golden goose.

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