Dec 29, 2008

Home Loans Interest Rates - Why Fixed is Never Fixed And Floating is Never Floating

THERE ARE BASICALLY two kinds of home loans interest rates: fixed and floating as already discussed in the post Fixed or Floating - Which is a better home loan interest rate?

However, in reality, neither the fixed rates are truly fixed nor the floating rates float with the changes in the interest rates. There are several grey areas.

Why the fixed housing Loan interest rate is never fixed?
The so-called fixed rate is not all that fixed. A true fixed rate is one which remains fixed during the entire duration of loan. There should be no change by the bank/HFC under any circumstances.

However, by inserting an early reset clause in fixed rate loan agreements, banks make sure that the fixed rate is nothing but flexible rate making a mockery of the difference between fixed and floating rates. The fixed rate is kept fixed for a few years only -– usually 2 to 5 years -– and could be changed after this period at the discretion of the bank.

Of course, a few banks/HFCs (e.g., ICICI Bank and HDFC) also provide fixed rates for the entire duration of the loan but these are usually even higher than temporary fixed rates which makes them unviable and defeats the purpose.

Why the floating housing Loan interest rate is never floating?
Floating interest rates are those which are linked to a benchmark and where the interest rate varies throughout the tenure of the loan based on changes in the benchmark. Transparent floating rates are those where the benchmark is publicly available and market determined.

If you go in for a floating rate, you obviously assume that whenever there is a fall in the interest rates, the banks/HFCs will pass on the benefit to you. But it does not happen. Why? As far as floating loan rates are concerned in India, banks peg them with internal benchmarks – Prime lending rate (PLR) or Mortgage reference rate (MRR) – rather than external benchmarks whereas internationally, variable rates are pegged to market benchmarks such as Libor.

These internal benchmark or base rates are under full control of the lenders. There is no transparent manner of determining the adjustment in the benchmark rate. The frequency and extent of adjustment is totally at the discretion of bank/HFC which leaves the borrowers at the bank’s mercy. Whenever there is a reduction in interest rates, banks make sure that there is no change in the internal benchmark so that existing customers keep on paying the same EMIs.

Now the question arises is that how the banks are able to offer better and concessional floating rates to new customers while charging the higher rates from existing customers? The bank does this by offering to the new customers a discount on the benchmark rate rather than lowering the benchmark. Put another way, bank lure the new customers by giving a discount on PLR without lowering it.

No doubt, this is an unfair trade practice but who’s there to question them?

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