Why floating home loan rates never drop

Part I: 5 GREAT reasons to buy a house even now

The Indian home loan market, bedazzled by the low rate home loans, forgot to ask one basic question: what is my floating rate loan benchmarked to?

A floating rate loan is one, which is pegged to a rate and should rise and fall with the benchmark, according to the rise and fall of the cost of funds in the country. So far so good, but the most obvious things break down in India because the organised institutions profit from and exploit the financial illiteracy of the retail customer. Here is how benchmarks lose relevance in India.

What is a benchmark? A benchmark is usually a rate that is used as a yardstick to either evaluate performance or set other linked rates in the market. For example, diversified equity funds use the Sensex as a reference point for their funds' performance. A good benchmark, of course, needs to be independent.

This means that the person measuring performance or using it to set other rates should not be able to influence it in any way. Hence, the mutual fund rules have the need for an independently determined benchmark (the market determines the Sensex and not one fund or company) to enable the investors to evaluate performance.

The same rules do not apply in the home loan market. Who, do you think, sets the 'benchmark' prime lending rate that your loan floats against? The RBI? No, it is the banks themselves who fix the benchmark.

This gives them the ability to change the benchmark at will and introduce new ones when old ones stop going their way. For example, ICICI Bank has two benchmarks in operation. Borrowers till early 2004 are on what is called the Internal Retail PLR (or RPLR) and those after that are on Floating Reference Rate (FRR). This, in early 2004, was set 2 per cent lower than RPLR, at 7.75 per cent.

What this means is that instead of passing on the benefit of the falling rates in 2004, the bank preferred to float a new benchmark, that was lower, rather than reduce the old one.

New customers got a market benchmarked competitive rate, and the old customers, who thought their rates would float down, continued to pay more - defeating the very purpose of being on a 'floater'. Today these benchmarks are at 10.25 per cent for FRR and 12.25 per cent for RPLR.

And then there were none. The only banks that tried out independent benchmarks in India were ING Vysya and Kotak Mahindra Bank, and this October, both withdrew these. For Kotak Mahindra Bank, the benchmark was its own one-year fixed deposit rate, along with a regular PLR-based (internally fixed) rate.

The FD-linked rate would truly reflect the cost of funds because a hike in the FD rate would mean that the bank would have to pay its lenders a higher rate as well. Mid-October, the FD-linked rate was recalled. ING Vysya used the three-month FIMMDA-NSE Mumbai Inter-bank Offer Rate (Mibor) index operated by the National Stock Exchange.

This is as independent as a benchmark can get and most countries use a similar inter bank rate as a measuring rod.

Mibor rates have ranged from a low of 5.51 per cent in January 2005 to a high of 8.63 per cent in March 2006, and are ruling at 7.48 per cent today. A loan at Mibor plus 2 would have moved from a high of 10.63 per cent to a low of 7.51 per cent over this time period without the bank being able to influence its movement - up or down. It is indeed a pity that the only truly transparent home loan benchmark in India was discarded before it could become the industry standard.

Though both banks cite customer indifference to the independent benchmark rates as the main reason for dumping these, could it be that these banks were losing competitive margins because of not being able to set the rates as other banks with captive benchmarks were doing?

What now? The market is left with no independently fixed home loan benchmark. Two things can happen - RBI can make it mandatory for banks to disclose transparently their benchmarks like banks in Australia. Or, the RBI can make it mandatory for banks to fix home loans to an independent benchmark, like the Mibor. Outlook Money is rooting for option two.

Till then, carefully look at what your loan is benchmarked to and start engaging with the banking ombudsman in case you are unhappy with the way your bank tinkers with its benchmark.