Reset Of Floating Interest Rate On Equated Monthly Instalments (EMI) Based Personal Loans

Introduction

In the dynamic landscape of personal finance, the year 2023 has brought forth significant changes in the structure of Equated Monthly Instalments (EMIs) for personal loans in India. One of the most noteworthy changes is the reset of floating interest rates on these EMIs.

The Concept of Floating Interest Rates

Floating interest rates, also known as variable interest rates, are rates that are subject to change in response to fluctuations in market conditions. Unlike fixed interest rates, which remain constant throughout the loan tenure, floating rates can be adjusted periodically, reflecting changes in benchmark rates or economic conditions.

The Reset Mechanism in 2023

In respect of the EMI based floating rate personal loans, in the wake of rising interest rates, several consumer grievances related to the elongation of loan tenor and/or increase in EMI amount, without proper communication with and/or consent of the borrowers have been received. In order to address these concerns, the Regulated Entities (RE) are advised to put in place an appropriate policy framework meeting the following requirements for implementation and compliance:

• At the time of sanction, REs shall clearly communicate to the borrowers about the possible impact of change in benchmark interest rate on the loan leading to changes in EMI and/or tenor or both. Subsequently, any increase in the EMI/ tenor or both on account of the above shall be communicated to the borrower immediately through appropriate channels;
• At the time of reset of interest rates, REs shall provide the option to the borrowers to switch over to a fixed rate as per their Board approved policy. The policy, inter alia, may also specify the number of times a borrower will be allowed to switch during the tenor of the loan;
• The borrowers shall also be given the choice to opt for (i) enhancement in EMI or elongation of tenor or for a combination of both options; and, (ii) to prepay, either in part or in full, at any point during the tenor of the loan. Levy of foreclosure charges/ pre-payment penalty shall be subject to extant instructions;
• All applicable charges for switching loans from floating to fixed rate and any other service charges/ administrative costs incidental to the exercise of the above options shall be transparently disclosed in the sanction letter and also at the time of revision of such charges/ costs by the REs from time to time;
• REs shall ensure that the elongation of tenor in case of floating rate loan does not result in negative amortisation;
• REs shall share / make accessible to the borrowers, through appropriate channels, a statement at the end of each quarter which shall at the minimum, enumerate the principal and interest recovered to date, EMI amount, number of EMIs left and annualized rate of interest / Annual Percentage Rate (APR) for the entire tenor of the loan. The REs shall ensure that the statements are simple and easily understood by the borrower.

Further, the REs shall ensure that the above instructions are extended to the existing as well as new loans suitably by December 31, 2023. All existing borrowers shall be sent a communication, through appropriate channels, intimating the options available to them

Implications for Borrowers

For borrowers, the reset of floating interest rates introduces an element of uncertainty into their financial planning. While the initial months or even years of the loan might bring lower EMIs due to favourable market conditions, subsequent resets could lead to fluctuations in their repayment obligations. This requires borrowers to be more vigilant about their loan terms and monitor market trends that influence interest rates.

However, it’s not all negative for borrowers. During periods of falling interest rates, borrowers can benefit from reduced EMIs, which can ease their financial burden. Additionally, floating interest rates tend to be more aligned with prevailing market rates, making loans potentially more affordable in the long run compared to fixed interest rate loans if market rates remain stable or decrease over time.

Implications for Lenders

For lenders, the reset of floating interest rates necessitates a robust risk management strategy. While these rates can attract borrowers during low-interest rate periods, they can also expose lenders to increased risks during periods of rising rates. To mitigate these risks, lenders need to adopt sophisticated modeling and forecasting techniques to anticipate potential shifts in market conditions.

The reset also calls for transparent communication between lenders and borrowers. Lenders must ensure that borrowers are fully informed about the possibility of rate changes, providing them with the necessary information to make informed decisions about their loans.

Impact on the Financial Ecosystem

The reset of floating interest rates on EMIs for personal loans has broader implications for the financial ecosystem in India. Firstly, it promotes a more responsive lending environment, allowing borrowers to benefit from lower rates during favorable economic conditions. This can stimulate borrowing and consumer spending, potentially boosting economic growth.

Secondly, the reset mechanism encourages financial literacy and awareness among borrowers. With the variable nature of floating interest rates, borrowers are compelled to educate themselves about market trends and economic indicators that influence interest rates. This can contribute to a more financially savvy populace.