The Old Way vs. The New Way
Before 2019, banks used internal benchmarks like the Base Rate or the Marginal Cost of Funds-based Lending Rate (MCLR) to set loan rates. These systems were often criticised because when the Reserve Bank of India (RBI) cut its policy rates, the benefits
were slow to reach customers. The process was complex and lacked transparency, as the rates were based on the bank's own internal costs. To fix this, the RBI introduced a new system to ensure policy changes are passed on more quickly and fairly.
Enter the External Benchmark Lending Rate (EBLR)
Since October 1, 2019, the RBI has mandated that all new floating-rate retail loans, including home loans, must be linked to an external benchmark. This system is known as the External Benchmark Lending Rate, or EBLR. Unlike the old internal systems, an external benchmark is a public, transparent reference rate that banks don't control themselves. This ensures that when the benchmark rate changes, your loan's interest rate adjusts in a predictable and timely manner, usually every three months.
The Most Common Benchmark: RBI's Repo Rate
While banks can choose from a few approved external benchmarks, the most commonly used one for home loans is the RBI's repo rate. The repo rate is the interest rate at which the RBI lends money to commercial banks. Think of it as the master switch for interest rates in the country. When the RBI wants to control inflation, it might increase the repo rate, making borrowing more expensive for banks. When it wants to boost economic activity, it might cut the repo rate, making funds cheaper for banks. This change directly influences the interest rate on your EBLR-linked loan.
How Your Final Interest Rate Is Calculated
Your home loan's interest rate isn't just the repo rate. It's calculated using a simple formula: External Benchmark (e.g., Repo Rate) + Spread + Credit Risk Premium. The 'spread' is the margin a bank adds to cover its operating costs and profit. This part generally remains constant throughout your loan tenure unless you refinance. The 'credit risk premium' is specific to you, the borrower. It is determined by factors like your credit score, income stability, and loan amount. A higher credit score (typically 750 or above) signals lower risk to the lender, often resulting in a lower premium and a better interest rate.
The Impact on Your EMI
Under the EBLR system, the connection between the repo rate and your Equated Monthly Instalment (EMI) is direct. If the RBI reduces the repo rate by 0.25%, your home loan's interest rate should also decrease by the same amount at the next reset date, which is typically every quarter. This would lead to a lower EMI or a shorter loan tenure. Conversely, if the repo rate increases, your EMI will also go up. This transparency allows borrowers to anticipate changes in their loan repayments based on the RBI's monetary policy announcements.
What About Fixed-Rate Loans?
It's important to note that this direct link to benchmarks applies to floating-rate loans. With a fixed-rate loan, your interest rate remains unchanged for the entire tenure, providing stability and predictable EMIs regardless of what happens to the repo rate. However, fixed rates are often slightly higher than the initial rates on floating loans. The choice between a fixed and floating rate depends on your risk appetite and your outlook on future interest rate movements. Given the transparency of the EBLR system, most new borrowers in India today opt for floating-rate loans.
