An old colleague called me up after reading one of my articles. We spent some time reminiscing about the old times and the people we had worked with before he came to the real reason he had called me. I knew he had lost his job in 2009 and his divorce had also put a lot of pressure on his finances. Although as a finance professional he understood the value of a good credit standing but circumstances had forced him to start defaulting on his car loan and credit cards after his entire savings were wiped out to pre-pay the home loan (his ex-wife got the flat) and to meet his day to day expenses during his unemployed days. He wanted to make a fresh start as he had just managed to get a job offer but his defaults were now beginning to affect his life. He was aware that he would need to repair his credit standing but was not aware of how to go about it. That rang a bell. I have been asked similar questions by a lot of people who either through circumstances (like my friend) or because of lack of financial discipline had defaulted on their financial obligations but were now wanting to make amends but did not know how to.

First a crash course on what happens when you default on your financial obligations. Today every lender is required to share data about the repayment history of their borrowers with at least one credit Information Company (generically known as CIBIL – since Credit Information Company of India Ltd Or CIBIL is the largest and the oldest of the 4 licensed credit information companies). It is a popular misperception that lenders share repayment data only about customers who default on loans. They are required to share data about the repayment of all their borrowers. So anybody who has taken in a loan (and that includes me as well) and is currently servicing it will find “his or her name in CIBIL”. But for most of us this is extremely useful. If I were in the market for a new loan now the banks will be happy to lend to me at good rates simply because they will discover that my existing loan repayments have been bang on time and the level of indebtedness is very reasonable. The issue of course arises if my credit information report shows defaults (current or past).

This credit report has special significance in today’s life (obviously after our school’s report card) as it determines the credit worthiness of any individual. The need for credit is important aspect of modern day life, which one can hardly do without. The day is not far when matrimonial alliances will be based on the credit reports of bride and the groom…so till death do us apart will probably be replaced by …till finances do us apart.

So if you have defaulted on your payments for any reason, your Credit information report will immediately disclose this status to any prospective lender. With a bad credit report it is highly unlikely that you can get any loan or credit card from any bank.

But all is not lost…you can slowly and gradually build your credit history all over again.

Now that you have been reported a defaulter, and you are burdened with debt, then what should you do? The help comes in the form of specialized credit counseling agencies who can assist you in such a situation. The well-known ones are ICICI initiated venture Disha Trust (www.dishafc.org) or Bank of India initiated Abhay Credit Counselling (www. abhaycreditcounselling.com) which assists you in negotiating with your existing lenders and re-structuring your debt, which can be curative and preventive both.

“The customized advise given by Disha Trust is absolutely free irrespective of the bank the customer has a defaulted with and not just ICICI bank,” shared Ms. Nutan Lugani - Counselor of Dish Trust. She adds, “ We hold extensive counseling sessions with the customers then work out an action plan and accordingly make recommendation to the banks. It is not mandatory for the bank to consider them but it is a win win situation for both, the bank and the customers. With restructuring or rescheduling of loans, banks recover their money without incurring costs of litigation etc. and customer gradually comes out of debt.”

So all is not lost. If you are considering obtaining a loan in future with low interest rates, you must have a healthy credit score. “Worrying too much about your bad credit history is not going to help, but doing the right things will certainly help, “ adds Ms. Lugani.

First start with paying off the re-structured debts and start the process of rebuilding your credit history. But remember, rebuilding your credit history is a slow process. It is a misperception that if you could somehow find the money and pay off all the debt now it will give you a clean slate. What the report will show is that you had defaulted in the past but that you cleared everything off at a particular point of time. That coupled with some other steps should help you in slowly rebuilding your credit history. Ms. Lugani says, “ Customers should not be obsessed about CIBIL credit report. They should first think about the loan, which they have to repay, and the need of the hour is how to come out of it, CIBIL report is secondary. Once you regularly start paying your debts in time then with the passage of time your credit history will improve.”

Remember CIBIL keeps your records for 7 years but displays the month-by-month repayment record only for the last 36 months. What it means is that if you start maintaining a clean history after re-structuring or paying off your loans than your credit history will start looking good after 3 years. Of course CIBIL also computes a Credit score (the process is internal to CIBIL) for each individual, which probably is based on the entire 7 years data. However, currently only a few banks use the Credit score so it is your visible data for 3 years that has more relevance.

In the meantime you can also start adopting measures, which enable you to rebuild credit history like taking secured credit cards, which are given against the security of your Fixed Deposits. Your credit limit will probably be raised in future if you have shown good financial behavior. These credit cards may not be your dream cards, but they are often the best option you have since you are unlikely to be eligible for their regular credit cards.

You can also opt for secured personal loans where an asset is required as collateral. It normally involves bigger sums of money, moreover secured personal loans are preferred by the lenders due to the fact that they are secured against your assets such as jewelry, securities such as shares/mutual fund units, bonds, NSC, KVP, Life Insurance policies with high surrender value, etc. All these loans (with the sole exception of Loan against property which is unlikely to be available for somebody who has defaulted in the past) are available irrespective of your credit record.

Ms. Lugani concurs, “Such customers should look at liquidating the existing liabilities by taking loan against some kind of security, whether it is of stocks and shares or gold, or consider borrowing from some rich relative who can give them at a much lower rate. But word of caution here is that check your expenses, do not increase your credit exposure and repay the present loan to salvage the situation immediately.”

You should pay more than the minimum payments each month if you cannot afford to pay off the credit card fully. Loan, whether big or small needs to be serviced and repaid regularly and on time. Service these loans religiously and the new disciplined you will also reflect in your repayment history in CIBIL records. In fact after three years the remanents of your bad history will no longer be visible.

So remember – slow and steady wins the race.

Next week I intend to cover how to get mistakes in your credit report corrected. I invite readers to share their experiences on this issue.

The biggest complaint of loan consumers in India who have taken loans on a floating rate has been that lenders are quick to raise rates for them when interest rates rise in the market but are very reluctant to reduce their interest rates when market interest rates drop. Till June 30, 2010 the floating rate products were priced with reference to their Benchmark Prime Lending Rate (BPLR). Clearly the BPLR system was not functioning in a transparent manner. After setting up a committee to examine the issue and a draft note inviting public suggestions the guidelines relating to the new “Base Rate” system have been made effective for all loans issued or renewed on or after July 1, 2010. So will this new Base Rate system be effective?

This article examines the difference between BPLR and Base Rate regime and the potential impact of the Base Rate system.

The rate is “to be computed taking into consideration (i) cost of funds; (ii) operational expenses; and (ii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin”. No this RBI pronouncement is not about the Base Rate but about the Benchmark PLR. If you see the non-binding “illustrative methodology” for the Computation of the Base Rate in the guidelines, it also more or less lays out the same set of parameters but just in greater detail.

So if the calculation method is similar how will Base Rate system make a significant difference?

For starters there are two big differences. Whilst each bank can choose its own benchmark for the cost of funds they will have to document the detailed formula for the calculation of the “Base Rate” and the method of calculation and follow it consistently (except during a brief six month transition period). This formula will need to be disclosed to RBI, which can also scrutinize that it is being followed consistently. This is unlike the BPLR regime where the BPLR was supposed to take into account the same set of parameters but no documentation was required and it was not open to RBI scrutiny. This is a significant difference between the two regimes since this forces the banks to follow a consistent method of calculating the Base Rate unlike the BPLR.

The second big difference is that, unlike the BPLR, banks are not allowed to lend below the Base Rate (again there are a few exceptions but they are not very relevant for this purpose). Now we all know that blue chip corporates are always able to get good rates from the banks. They are likely to be borrowing at interest rates very close to the banks’ current Base Rates. When market interest rates fall they will naturally expect to get better rates and naturally the banks will be forced to drop their Base Rates if they still want to maintain their share of this market. So apart from the point mentioned in the first paragraph, this factor will also exert downward pressure on the Base Rate when market interest rates fall.

If the transparency is so built in then why the doubt on whether the Base Rate system will be effective or not? Clearly the Base rate system is designed to be more transparent than BPLR. But unfortunately there is no requirement that the detailed formula of each bank’s Base Rate be made public (it is only to be available for review and scrutiny by RBI). Clearly RBI will need to set up a machinery to monitor and review these calculations to ensure that they are consistent, which given their focus on ensuring transparency is likely to function as an effective check on the proper implementation of the Base Rate system. It would be very interesting to find out whether the general public under RTI can access a specific bank’s calculation of Base Rate that is available with RBI.

As is likely the effective functioning of the Base Rate regime will significantly change the retail lending industry in India. Firstly as changes in the effective interest rate for the customer will depend on the “average” cost of funds rather than the “marginal” cost of funds any increases in market rates will take time before they are fully passed on to the borrower (see box for difference between “average” and “marginal” cost of funds). Whilst this is beneficial when interest rates increase it is also not so bad when interest rates decrease as, unlike the current situation, the consumer is likely to get some decrease immediately compared to none or very little in the current scenario.

+++++++++++++++++Box++++++++++++++++++++++

Difference between average and marginal cost of funds

Assume a bank currently has funds of Rs. 100 crores at an average cost of 10% (total cost of funds is Rs. 10 crores or Rs. 2.50 crores per quarter). Now the cost of funds in the market goes up by 1% pa. On an arithmetic basis the banks cost of funds should go up by Rs. 1 crore per annum or Rs. 25 lacs per quarter. However since a lot of the bank’s funds are in time deposits which are at a fixed cost - where the cost will rise only when the deposit comes up for renewal - immediately its cost may go up by only say 12.50 lacs for this quarter or only 0.50% p.a. Of course over a period of time as all the fixed deposits mature and are renewed at new higher rates the cost of funds will go up to Rs. 11 crore per annum or 2.75 crores per quarter). Thus the average cost -10% in this example changing to 10.50% or a change of 0.50% only - will always change slower than the marginal cost - +1% in this example)

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+++++++++++++++++Box+++++++++++++++++++++++

If you have an existing loan should you shift to the new Base rate regime?

Firstly there is no automatic shift to the new regime. You will have to ask your bank to shift you to the new Base rate regime for which they are not supposed to charge you any fees. If you are on an existing fixed rate loans (or in the teaser period where rates are still fixed) where the rate is lower than the current floating rate of 8.50% - 9% than wait till you are on a floating rate basis for shifting to the new regime. If you are paying interest rate in double digits then shift to the new regime immediately. If your existing lender is not giving you good terms for the shift or is not acting fast enough to shift you to the new regime then you should seriously consider shifting to a new lender altogether)

+++++++++++++++Box ends++++++++++++++++++++++

The National Housing Bank (NHB) which regulates the housing finance companies – HDFC, LIC Housing Finance, etc.- will also be forced to come out with a similar system for HFCs which will be good for the home loan consumers. Similarly the scheme will have to be extended to NBFCs also by RBI though that is likely to have a smaller impact on the loan consumers.

In any case the impact of this fundamental change will be felt only over a period of time – at least 6-12 months as interest rates change (likely to increase) during that period. Here’s hoping that this change has a fundamental impact on all loan consumers.

And No, this question is not asked in the political context with our Northeastern borders racked by chronic insurgency and of course the unrest in J & K.

It is not even in the context of a common single market where many foreign direct investors will testify that this is not just a rhetorical question. In fact the early investors in the India story discovered the maze of local taxes, levies and regulations divided India into many small markets (of which some were more profitably serviceable from manufacturing locations located outside India rather than from a location within India). Anyway much water has flown down the Ganges since those early days and the impending implementation of the Goods and Services Tax would perhaps be the culmination of a series of steps that have already been initiated in recent years to forge a common India market.

The question is in the relatively mundane context of Home loans. Recently I spoke to a friend of mine who wanted to a buy a flat in Kolkata while he was working in Mumbai. He wanted to use my expertise on home loan to suggest solutions for a problem that he was facing in getting a loan. He approached a bank in Kolkata who said they would have given him the loan as both the property and his income papers were in order, but they asked him to visit their branch in Mumbai to get a loan as he was working in Mumbai. When we came back to Mumbai after finalizing the property in Kolkata, he approached the branch of the same bank only to be informed to visit a branch in Kolkata as the property is in Kolkata and they need to value the property before giving the loan. This friend of mine had already paid Rs. 51,000 for booking amount and if he was unable to book the flat, the developer would return back only 50% of the booking amount (after negotiations as the developer was not ready to return a penny out of it). Tensed with all these issues, he called up asking me – Is India really one Nation? The property was ready to move in with all title documents and his loan eligibility was coming around to more than Rs. 20 lakhs (he needed only Rs. 14 lakhs).

I decided to do some research on the same as the number of people moving to other cities for work has been increasing significantly and this may be a common problem faced by quite a few of them who either have plans of relocating or to buy a property for their parents in their “home” city. We have also seen an increase in the number of similar queries we receive on Apnapaisa.com.

We did a round of mystery shopping as well as spoke to the major home loan players. Here is what we found. When we spoke to the players officially each of the players said that such loans are no problems as they have a single common system across the country. However the situation on the ground was a little different. From among the lenders we spoke to as mystery shoppers only HDFC and ICICI followed up on our initial call (we had dangled the bait of Rs. 70 lac home loan). Even the official we spoke to in a SBI branch assured us that they would be able to do the transaction subject to their normal credit and operational checks. The other two private sector banks and the one foreign bank that we spoke to (or visited) as mystery customers either told us that they could not do such a deal or did not respond back after taking down the initial details.

We already knew a few DSA’s (who are our clients as advertisers on our site) and we thought of getting this answered from them also. We spoke to a large DSA based out of Mumbai who serviced many banks. His feedback corroborated our own findings on mystery shopping.

Another DSA we spoke to in Mumbai (who did not work with either HDFC or ICICI) said he would be able to get the transaction done provided the project in Kolkatta was pre-approved by any of the banks he worked for.

I also did a bit of informal talking with the private sector banks that had turned down (or did not show much interest in) our mystery shopper. What came out was that none of them had an effective loan origination system across the country and unless the loan amount was big enough the amount of effort required to co-ordinate with another city was just not justified. Each office is driven by its own KRAs and as legal checking work done for another office was not counted as part of their KRAs this clearly did not enjoy any priority.

What it boiled down to was that a loan that was clearly falling within their credit and legal norms of the bank was being given up simply because of the mismatch of KRAs between the two branch offices. Of course for a determined customer this would still be possible but it might take a lot more time than usual.

The only saving grace to come out of this story was that at least for a few lenders India was a “single” country.

Amen.

Disclosure: Most of the banks mentioned in the article are advertisers on Apnapaisa.

The modern day consumer is in a perplexed state owning to the multiple loans he has to service for fulfilling his various needs/ wants.

So are these loans bad or bad?

Loans, probably being my ‘middle’ name, this question coming from me may surprise many as I have been advising consumers on various facets of loans for many years on a day-to-day basis. Here I would like to draw a parallel from Bollywood movie Dayawan where film ends with a question by child character – Was Dayawan (the protagonist who plays a mafia don with a heart of gold) a good person or a bad person?

So it depends on your perception.

They are good if you are able to manage and balance your loan portfolio, besides having a good repayment capacity. But it becomes a messy affair if they are not managed well or your repayment capacity takes a beating.

Ideally loans should be a means of creating assets or enhancing earning capacity. Then they are also a means to attend to unexpected emergencies. They are a “must” whatever situation you are in but the purpose of the loan plays a crucial deciding factor. The other deciding factor is the cost of the loan. The purpose of loan must also be cost effective. As you need loan to fulfill the need for more than one asset at a time, it is very important to priorities your loans.

If you are undertaking “hair cutting” course for Rs. 20 Lacs, it may not be worthwhile, as the earning capacity may not be enhanced that much. Even when the loan is for a good purpose say paying the fee for an educational course that will substantially add to the earning capacity but if the cost of the loan is too high, then it will not remain a good loan.

At the top of the hierarchy most loans taken to fund education for self or a family member would normally qualify to be a “good” loan as they create substantial earning capacity relative to their cost and are normally available at a reasonable interest cost. Tax breaks on the interest would also reduce the post tax of the loan substantially.

Second would be loan taken to fund a reasonable cost house for your own residence. Normally this asset price appreciates in value and will also act as a source of pension income or retirement through the medium of a reverse mortgage. Third would be a loan taken to buy your own reasonably priced vehicle (two-wheeler or four-wheeler). This may result in a boost in your productivity given that public transport in most cities in India is quite poor.

Then there are loans taken for consumption such as for funding or an expensive/ luxury consumer durable.

Basically there are two types of loans - Secured loans are loans such as home loan and vehicle loans. They are backed by your assets in order to minimise the risk assumed by the lender. The assets may be forfeited in case there is a failure to make the necessary payments.

Whereas unsecured loans are personal loans and credit cards, where the lender has no entitlement to any of the borrower’s assets in case borrowers fail to repay the loan. Such a loan normally carries a higher interest rate than a secured loan. Repayment plans of loans vary based on each type of loans. Home loan repayment plans can be as high as 20 years or more, whereas vehicle loans can be repaid in 3, 5 or 10 years, and the credit period for credit cards is around 50 days.

The consumerism boom fuelled by the presence of modern places of worship – Malls, has led to the phenomenal growth of plastic money. Swipe…swipe…swipe is the new mantra chanted by one and all. And the prasad of this mantra is debt…debt…and more debt. The debt on the credit card for longer duration will land you in a financial mess. The borrowing on credit card should not exceed 30 – 45 days, as interest charged is very high on such credit.

Last would be loan taken for speculative purpose such as investments in stock markets. These are strict No-No.

I would like to quote Benjamin Franklin here: “Remember, credit is real money,” which we tend to forget.

Thus it is important that you make it your personal goal to pay your credit on time as it will impact your credit rating.

So to end – remember loans can be very useful – nay – essential to improve the quality of your life and your future generations. At the same time it has the potential to destroy your life if used unwisely.

The regulator does not like them. The consumers cannot seem to have enough of them. Yes I am talking of the teaser rate home loans that have become so popular in 2009. Whilst most of the banks had withdrawn these schemes in the first quarter of this year, India’s largest bank State Bank of India doggedly kept the scheme on (albeit with increased rates from its earlier scheme). Given the universal expectation that interest rates are bound to go up this year, the customers found the safety of fixed rates even if only for a limited period quite attractive relative to a regular floating rate product. This consumer preference has forced market leader HDFC to come out with its own teaser rate loan scheme and ICICI bank has also joined the party this week. The teaser schemes, Bank of Rajasthan and LIC Housing Finance always had the scheme on and their schemes are continuing. As of now the teaser rate loan schemes of HDFC, ICICI and SBI are scheduled to apply only for sanctions till April 30, 2010. The partial disbursement should be latest by June 30, 2010 in case of HDFC and ICICI. However it is expected that the schemes will be extended at least till the end of this quarter.

Let’s take a quick look at some of these schemes and their salient features for a loan of Rs. 30 lacs for 20 years:

So how should a consumer decide on which schemes to go for?

Firstly if you are in the market for a new home loan, it is advisable to choose from one of the above teaser rate schemes (versus a regular floating rate product from them or other lenders) since it will give you the safety of low fixed rates during the next few years during which interest rates are likely to rise. Between them also the real difference will arise once the fixed rate period is over and the time comes for the floating rates to take over. At that time how accurately the lenders reference rates reflect the changes in the market interest rates will determine what the actual effective cost is for the consumer. (See article on how lenders do not pass on benefit of lower interest rates to their existing loan consumers in the DNA of February 13, 2010) . It is here that the public sector banks have a relatively better record. The Mohanty committee set up to suggest changes to make credit pricing more transparent found that whilst the BPLR of all banks moved up when RBI increased Repo rate the BPLR of public sector banks were impacted (lowered) more significantly than their private or foreign sector counterparts when RBI dropped Repo rates.

In any case this is an area with developing implications as the new Base Rate system scheduled to be operational in the second half of 2010 should improve the transparency on fixation of reference rates for floating rate loans.

However the biggest opportunity is for existing home loan borrowers who are in a regular floating rate loan. Chances are that you are already paying a fairly stiff rate (probably in excess of 9.50%) compared to what is available for new loan consumers today. Get rid of your inertia and shift now to a teaser rate loan and do it now. This is a small window of opportunity, which may not remain open for too long.

“Loan rates set to be more transparent” screamed newspaper headlines on Thursday after a draft RBI circular asked banks to shift to a “base rate” mechanism from the existing “BPLR” w.e.f April 1, 2010.

The existing “BPLR” structure for pricing floating rate loans has exhibited what bankers politely call “downward stickiness”, which means that the BPLR refuses to go down (or goes down reluctantly and at a slower pace) when bank’s cost of funds fall, though it is quick to go up when their cost of funds go up. In effect existing loan consumers continue to pay higher interest rates even in a falling interest rate market but are forced to pay more when interest rates go up. As taking a loan (primarily home loan) becomes more prevalent it affects millions of middle class households and the furore over this non- transparent method of fixing floating rate loan products has reached feverish pitch.

The banks on their part give a curious argument to justify charging more to their existing home loan consumers whilst doling out lower rates to attract new customers. They claim that as interest rates fall only for the new incremental deposits and since the existing consumers are funded from existing deposits (which are at a higher rate), they cannot be given the benefit of the fall in rates immediately. The reason this argument does not appear wash is because by this token when interest rates rise, only the new customers should be paying the higher rate (since only they are funded from the new high cost deposits) whilst the existing loan consumers should continue to pay less. Of course this never happens.

When interest rates go up, they go up for both the new and old customers. Bankers again have a justification for even this. According to them when interest rates go up their existing depositors break their lower cost deposits to make fresh deposits at higher rates. There is no data presented by them to support this contention (of customer churn old deposits for new deposits at higher costs) and it is difficult to believe that a large body of Indian depositors overcome their legendary inertia just to take advantage of a 0.25% or 0.50% increase in deposit rates.

In any case this completely overlooks the fact that managing the “treasury” is a core function of the bank and it cannot pass on this responsibility (or cost) to its loan customers. Another argument given by bankers is that if the true cost of this “treasury” management was to be included in the loan pricing then all loans will be more expensive to start with (though they will be transparent). I am willing to stick my neck out and say that given the choice between a cheaper but non-transparent loan to a slightly more expensive but transparent loan, most consumers will opt for the latter. In fact this presents a unique opportunity for a consumer bank but more of that later.

Now coming to the draft RBI circular which differs from the recommendations of the Mohanty committee in two very crucial aspects. Firstly the committee had recommended that the “Base Rate” be calculated in a very specific manner with the starting point being the bank’s 1 year deposit rate. What the RBI circular says is “While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are: (i) cost of deposits; (ii) adjustment for the negative carry in respect of CRR and SLR; (iii) unallocatable overhead cost for banks”. In effect each bank will be able to fix its own base rate without necessarily having to justify its calculations. This does not give much confidence that anything much will change from the BPLR dispensation. There have been numerous exhortations from the regulator that BPLR was to be fixed with reference to the cost of funds of a bank.

Secondly the committee had recommended that the Base Rate be revised at least once every quarter which is again not insisted on in the RBI’s draft circular.

So unless something changes dramatically, the expectation that loan interest rates will be fixed in a more transparent manner, is likely to take a long time to realise. There is one (unintended?) impact of the draft circular. The artificial cap on interest rate on education loan may no longer apply and hence this crucial (but risky product from the bank’s perspective) may at last take off.

To conclude here, I think that the path to more transparent loan pricing will have to be traversed through legislation rather than from regulation.

Let’s see if our political class will come to the rescue of the loan consumer whereas regulator has been unable to do so.

The RBI has recently expressed its concern about the teaser loans, stating,

“In the area of housing loans, teaser rates are increasingly being offered which is a cause for concern. I hope banks are ensuring that borrowers are well aware of the implications of such rates and the appraisal takes into account repaying capacity of the borrowers when the rates become normal.”

The point being made was that when the “teaser rate” period is over (2-3 years in most cases) and interest rates shift to the normal floating rates prevalent at that time the consumers may not be able to cope up with the resultant increases in EMIs (especially if, as widely expected, interest rates go up significantly in the meanwhile).

I give a small calculation here for the better understanding of ‘teaser rigmarole.’ Take the case of a typical 30-year-old salaried person with a net salary of around Rs. 40,000. As per the eligibility calculations he would be able to get a loan of Rs. 20,00,000 from State Bank of India (SBI). (See box for eligibility calculation)

How do “teaser rates” work?

SBI who pioneered these loans prefers to call them “Low cost” loans rather than “teaser rate” loans. Whatever be the label, in the Indian context, it has meant loans in which the interest rates are fixed for the first 2-3 years (5 years also in a couple of cases) and which reverts to regular floating rates after the initial fixed interest rate period is over. For example for a loan of Rs. 20 lakhs SBI would charge a fixed interest rate of 8% in the 1^st year and 8.50% in the next 2 years and from the 4^th year onwards it will have a floating rate of 2.75% below SBI Advance Rate (currently 11.75%) effectively meaning that if SBI Advance rate remains where it is today the rate in the 4^th year will be 9% (SBAR of 11.75% minus 2.75% = 9%). The EMI per lakh on this basis works out to Rs. 836 in the first year Rs. 867 in the next 2 years and Rs. 895 after 3 years.

If he went for the normal option of regular floating rate loans he will get an interest rate of 8.75% (EMI per lakh of Rs. 884) and will also be eligible for a similar loan amount of Rs. 20 lakhs.

If we run a simulation to see what happens if the interest rates rise by 2% in 2010, 1% in 2011 and another 1% in 2012 – or a total of 4% in the next 3 years. As a result in the case of the SBI home loan the interest rates from the fourth year goes up to 13%. If he had gone for the floating rate loan the interest rate would be 10.75% (original rate of 8.75% plus 2%) in the first year, 11.75% in the second year and 12.75% for the period after that. The Instalment to Income ratio in both cases go up sharply from 44% to 57% (indicating that a larger proportion of the income will go towards servicing the home loan) at the end of 3 years and in both cases are almost at the same levels. This means that irrespective of the type of loan the degree of difficulty in repayment would be similiar in both the loans if rates increase steeply by 4% over 3 years.  In both cases an 8% annual increase in income will ensure that the Instalment to Income ratio remains at the original levels. Of course in the regular floating rate loan the consumer ends up paying for the increase in interest rates in the first 3 years also.This increase will ensure that the Installment to Income ratio falls back to the mid forty levels that are considered safe by Indian standards.

How is loan eligibility calculated in a “teaser rate” loan?

The loan eligibility is calculated taking into account the EMI after the teaser period is over. As per the above example the EMI per Lakh of loan in the 4^th year would be Rs. 895. Typically the banks assume that 40% to 50% of the net income is available for repayment of home loan. Therefore from the income of Rs. 40,000 about Rs. 16,000 (40% of Rs. 40,000) to Rs. 20,000 (50% of Rs. 40,000) is available to be paid as an EMI. Based on an EMI repayment capacity of Rs. 16,000 to Rs. 20,000 and an EMI per lakh of Rs. 895 we can back calculate the loan eligibility amount at Rs. 18 lakhs to Rs. 22 lakhs or say around Rs. 20 lakhs.

So clearly whether the consumer chooses the “teaser rate” product or the regular floating rate product he would face some difficulty if interest rates rise steeply as the IIR will increase to uncomfortable levels of 55%+. The IIR can fall back to reasonably comofrtable levels if net income rises by 8% p.a. which should not be a big issue if our overall economic growth  does not falter.

What would perhaps help, both banks and consumers, is if a transparent regime is put in place to ensure that increases in interest rates (and decreases for that matter) are worked out on a transparent and objective basis so that consumers are better prepared for such increases and the actual increase doesn’t come as a shock to them.

The Reserve Bank of India has hiked the Cash Reserve Ratio by 0.75% to 5.75% (as against the existing 5%) in the third quarter review of monetary policy announced today which will be implemented in two stages. The Central Bank has left unchanged the Reverse Repo, Repo, and Bank rate at 3.25%, 4.75%, and 6% respectively.

So what does all this translate into for customers like you and me?

For what is CRR and how it affects interest rates, please see box.

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What is Cash Reserve Ratio (CRR)? Banks are mandated to keep certain percentage (now increased to 5.75%) of their deposits with RBI. This is the Cash reserve and the %age required to be kept as a cash reserve is called Cash reserve ratio or CRR. Thus, an increase in the CRR leads to banks being forced to keep more money with RBI reducing the funds available for lending. As less money is available to the bank to lend there is bias towards increase in rates as per the normal laws of supply and demand. So an increase in CRR will normally result in an increase in interest rates (and vice versa a reduction in CRR will normally result in a reduction in interest rates).

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The quantum of the increase is at 0.75 % was a tad higher than the market consensus of around 0.50%. RBI has increased the target growth for 2009-10 from 6% to 7.5% for the year, and have clearly indicated that their policies will now shift from ‘managing the crisis’ to ‘managing the recovery’, and thus reverse some of the earlier steps undertaken to provide liquidity in the market. They have also indicated that the “recovery is getting established and inflation fears are coming true”. In fact we can expect more such action including increase in Repo rates, Bank rates Reverse repo rates. (See box for what these rates are and their impact.)

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What is Repo Rate?

The repo rate is the rate at which RBI lends short-term money to banks under a specific secured mechanism. When the liquidity in the markets is high, the RBI increases the rate at which it lends to the banks to make it more expensive for the banks to borrow money from RBI. Thus banks have more expensive money with them to lend to consumers and have in turn to increase their own rates. Thus increase in repo rates have a bearing on other interest rates like your bank FD rates, home loan rates, and so on.

What is Reverse Repo Rate?

It is a mechanism by which banks can park short-term money with RBI. The rate of interest that the bank gets from RBI for such money thus becomes the floor rate for all interest rates at this return is guaranteed to the banks. When this rate goes up naturally the overall interest rate will tend to increase as well.

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How are consumers impacted with these economic moves?

If you strip away the conservative language favoured by all regulators, it clearly means that interest rates are on their way up as far as the regulator is concerned, and hence we will definitely see an increase in overall interest rate during this year. But the quantum of the increase will depend on how inflation shapes up, and that in turn will depend on a host of factors such as demand for credit, monsoon, etc.

Still the question remains how does it affect you and me?

For savers and investors: If you are thinking of depositing monies with banks, then it is advisable not to get into long term deposits. Instead of making a 5 - year deposit you should make a 6/12 month deposit, as it is very likely that when the renewal comes up then you will be in a position to get far better rates.

For new loan consumers:

If we look from a borrower’s perspective, interest rates may not get affected immediately (in the next 45 days or so) but clearly there will be an increase in interest rates the near future. So if you were going to buy a home or a car in the near future, then it makes sense for you to prepone your borrowings immediately and go in for the current teaser rates into the safety of fixed rates for at least 2-3 years. Teaser rates for a year or so are available in car loans as well and customers should look at that also.

For existing loan consumers:

Well if you were smart enough to have taken a teaser loan in the last 6-9 months then just wait and watch since you have already made the right move. But if you have borrowed on a regular floating rate, then you should immediately shift to a teaser rate loan. Do it in next two – three weeks itself before interest rates start to harden or the teaser rate schemes are withdrawn. I repeat – do it now!!! If necessary the shift can be to the same bank from their regular floating rate loan to a teaser rate loan.

Sure the teaser rate loan only secures you for the medium term (the first 2 -3 years)

But it is better than nothing. To quote John Keynes “ ….in the long run all of us are dead….!!!

Amidst all the hype & hoopla surrounding the home loans (teaser loans), there are customers who are still facing the dilemma to remain fixed or to float. They do not want the risk of floating especially when interest rates move upwards, at the same time they do not want high pure fixed rates. They want to avoid the risk, at least for a certain portion of the loan, and some lender’s answer to such an arrangement is known as Hybrid loans.

So what are these Hybrid loans?

It is a combination of fixed and floating, also known as partly fixed and partly floating. Under this scheme, a part of your loan is locked under ‘fixed’ and the rest is under floating – the adjustable rate of interest. In fact it is supposed to be a median option between fixed and floating interest rates. This product works best for the people who are not clear about the rate movements and do not want to take the particular stance. Depending on the risk appetite and risk perception of future rate movements, you have evaluated the pros & cons of both fixed and floating but are unable to come to any conclusion. So, as per the companies, hybrid loan is another option which can work well for customers like you.

In case of hybrid loans, there are two parts to the loan agreements, one for fixed and another for floating.

That means that if you take a loan of Rs. 20 lakh and you feel that interest rates will increase, you can choose to take 60 per cent of Rs. 20 lakh as a fixed rate home loan and the remaining as floating. The proportion can change depending on your risk appetite.

In case rate moves up, you normally have an option of foreclosing your floating component of the loan with no pre-payment penalties. In case you decide to foreclose the loan locked under the fixed portion, standard pre payment penalty will apply unless you have negotiated otherwise.

Normally the company offers an option if interest rates move up, you can get the fixed portion of your floating loan into floating. You can convert the fixed component into floating by paying a conversion fee of 0.5% - 2% or as charged by your bank of the outstanding loan amount.

In the event that interest rates rise, the portion under fixed rate will be your buffer. And if they fall, then you gain on the floating component and lose on the fixed.

This product may work well for people who take large loans because they are more interested in hedging their risks. If instead of the hybrid loan, you decide to go for the fixed interest rate loan, make sure that your loan is indeed fixed for the entire duration of the loan. But lenders mostly put in a clause in some of their loans under which they reserve the right to amend the ‘fixed’ rate in the event of an ‘extreme change in money market conditions’.

Still fixed or floating dilemma has been eased out with the introduction of Teaser loans earlier this year, where interest rates are fixed for certain tenures say three years. After that option lies with you to choose either to chose fixed or floating which is 2.5% below the PLR.

Following suit, many PSU banks have come out with offers where they are offering low attractive fixed rates for the first 3-5 years (8-8.5%) with rates reverting to the standard floating rate after that period is over. These kind of loans are popularly referred to as Teaser loans where rate in the initial years is fixed as well as low. Private players HDFC and ICICI have recently joined the bandwagon. They announced a similar teaser loan product early December, 2009. Thus presenting clearly a good option for the consumers who want to stay away from tracking home loan rates at least for a certain period of time.

So what does a teaser rate home loan mean for the Indian consumer? It means that there is a low initial interest rate that is fixed for a specified period (1 year to 5 years) and the floating rate as specified becomes applicable thereafter.

Given below is an analysis of the some of the teaser rates home loans available in the market for a 20 year home loan of Rs. 30 lacs.

Home Loan interest rates for 20 years, Loan amount of Rs.30 Lakh - as on December 23, 2009

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BANK For first year Overall effective rate

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SBI Easy Home Loan **** 8 8.76

CANARA BANK *** 8 9.33

HDFC** 8.25 8.63

ICICI BANK * 8.25 9

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****SBI offers 8% fixed for the 1st yr, 8.5% fixed for the next 2 yrs, 4th yr onwards borrower has an option of choosing either floating rate which will be 2.75% below SBAR or fixed rate which will be 1.25% below SBAR. *** Canara Bank offers 8% fixed for 1 yr, 9% fixed for next 4 yrs, thereafter min. 10% for loans upto Rs 30 lakh.

**8.25% fixed till 31st March 2012, thereafter prevailing floating rate (currently 8.75%)

*8.25% fixed for 2 years , 3^rd onwards it is FRR (currently 12.75%) minus 3.50% = 12.75% -3.50% -= 9.25%

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But it is certainly not a one time decision, you need to review your decision at fixed intervals. Basically, partly fixed and partly floating interest rate loan lack interest rate transparency. The so-called fixed portion may be varied and there is no objective mechanism to ensure that floating rate floats down.

Mixed rates are normally not recommended mainly because of the non-transparency of the banks on both these (fixed & floating) rates. The risks are there even if you opt for pure fixed or pure floating, still you are not exposed to dual opaqueness.

It is advisable to use online home-loan calculators on sites like www.apnapaisa.com to estimate the Estimated Monthly Installments (EMI) for the loan amount you require. You will also need to understand the difference between Fixed-rate, floating-rate, the teaser rates or the combo (hybrid) rates to determine the rate type that is best suited for you.

Hence, it is important to evaluate all the pros & cons before making a decision in favour of hybrid loans.

After initially playing down the teaser home loan product first introduced by SBI in January 2009 , market leader HDFC has decided to join the bandwagon. They announced a similar teaser loan product on December 1, 2009. ICICI bank announced its own teaser plan on the weekend. This clearly is a good time to be a new home loan customer.

So what does a teaser rate home loan mean for the Indian consumer. It means that there is a low initial interest rate that is fixed for a specified period (1 year to 5 years) and the floating rate as specified becomes applicable thereafter.

Given below is an analysis of the some of the teaser rates home loans available in the market for a 20 year home loan of Rs. 30 lacs.

Source : Apnapaisa Research Bureau

Effective rates have been worked out assuming the floating rates will be what they are today.

*HDFC effective rate worked out assuming lower teaser rates are applicable for 24 months.

HDFC and ICICI bank’s dual home loan rates are now in competition with SBI’s Easy Home Loan scheme which offers competitive rates at least for the first three years.

Do teaser loans make more sense then regular floating rate products?

Interest rates are thought to have bottomed out and are widely expected to go up next year and these teaser loans provide a cushion at least for the next few years. After teaser period is over, if your lender does not offer you market determined floating rates, you should switch your loan to another lender. The effective rate of these teaser loans are also fairly good and hence it should clearly be preferred over regular floating rate loans which might increase rates next year itself based on current market conditions.

So what should a consumer look at while choosing a lender based only on teaser rates?

The big variable in most cases is the applicable floating rates after the initial period of fixed rates is over. In working out the effective rates it has been assumed that the floating rates will be what they are today. This may not necessarily be true as different banks may follow different strategies on floating rates at that time. One should not forget the story of people who had gone in for a similar teaser rate home loan scheme floated by a foreign bank in October 2003 with interest rate of 6% for 1^st year and 6.50% for 2^nd year (against the then prevailing floating and fixed rates of 7% and 7.50% respectively) and floating rates thereafter. By the time the two year teaser period was over, the bank had lost interest in the home loan market and interest rates were jacked up to double digit levels even as the prevailing interest rates were still around 8.5 –9.50 %. As a result a lot of consumers were forced to switch their loans to other lenders. It is in this context that the PSU banks are likely to score over their private sector counterparts. The report of the working group on Benchmark Prime Lending rate appointed by the RBI to look into introducing transparency in fixation of floating rates by the banks has remarked that “ An increase in the repo rates was observed to bring about a contemporaneous change in modal BPRLs of the private sector banks and major foreign banks and a lagged response in the case of the public sector banks. A decrease in the repo rate had a significant contemporaneous impact only in the case of the public sector banks”. In simple English what the group’s research showed was that the PSU banks were slow to raise floating rates for existing customers when repo rates rose and were quick to drop rates for existing customers when the repo rates dropped. Off course the fixation of floating rates will hopefully be a little more transparent in the next few years but if doesnot home loan borrowers from PSU banks will hopefully not be required to make the effort to switch lenders.

The other issue is that people should also look at pre-payment charges and any upfront charges (processing fees/stamp duty/legal charges, etc.).

But perhaps the most important thing is the property itself. If you are buying an old property (greater than 25 years) or a resale property that has gone through many owners or an under construction property that is still in the initial stages of construction then it might be useful to consider the private lenders simply because they have developed expertise on dealing with the issues arising from such transactions.

Can existing home loan consumers take advantage of these schemes?

On paper all the banks (including PSU Banks) that offer these teaser products are offering it only to these new customers and not to their existing customers. So if you are an existing loan customer of any of these lenders and want to take advantage of these schemes, you should switch your loan to another lender (i.e. become a new customer to that lender). All the lenders offer the teaser rate products to existing home loan customers of other banks. Ironic but it is not available to their own customers.

So ‘Teasers’ do make a difference in the lives of new customers as well as existing customers.