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Home loans indexed to the internal reference rate vs home loans indexed to the repo rate

The interest rate applicable on a home loan is one of the key factors that determines whether your loan is affordable or unaffordable on a monthly basis and how much interest you end up paying over the term. Thus, it is imperative that you understand how interest rates work before you qualify for a home loan to make an informed decision.

The interest rate varies from person to person

One of the first things to note is that the interest rate offered to you depends on your profile. So while lenders typically advertise a rate, that number is the starting range and is typically offered to applicants with the highest credit profiles.

To qualify for the lowest possible interest rate, your profile must have a strong credit history and a strong employment, income, and financial profile, among other factors. For example, an applicant with a credit score above 750, employed by a reputable organization, will be offered a competitive interest rate, provided they meet the lender’s other eligibility and risk criteria.

How Home Loan Interest Rates Change

Home Loan Interest Rates are linked to a reference rate with a fixed spread, and when the reference rate increases or decreases, the corresponding interest rates also increase. The reference rate that will be linked to your interest rate depends on several factors, the first of which is the type of lender you choose.

  1. Banks: The RBI requires banks to link mortgage interest rates to benchmarks such as:
    1. The Repo Rate governed by the RBI,
    2. Indian government 3/6 month treasury bill yield published by FBIL (Financial Benchmarks India Pvt Ltd), or
    3. Any other reference rate published by FBIL.
      Of these, a number of major banks choose to link their home loans to the RBI repo rate or Treasury bills.
  2. HFCs: HFCs (Housing Finance Companies) can choose to link their interest rates either to an external benchmark, as shown above, or to an internal benchmark.

Another factor that can affect your interest rate is the addition of a risk premium. For example, suppose you have a home loan at an interest rate of 7.5% per annum. If you are in default, the lender has the right to increase your interest rate. Indeed, as a borrower, you now present a higher risk to the lender. The exact number by which your interest rate will be increased is not fixed and is at the sole discretion of the lender. Note that some lenders also charge this risk premium at the time of acquisition – in addition to the reference rate and the defined spread, based on the risk categorization.

Learn more about benchmark interest rates

Both internal and external referrals have their advantages, and the right choice depends on the market scenario and your preferences as a borrower.

  1. Internal reference rates
    1. Different HFCs refer to their internal reference rates by different names; some of the commonly used terms include floating reference rate (FRR), prime lending rate (PLR), etc.
    2. Internal benchmarks are set by the lender and are subject to change based on various factors, including the lender’s cost of funds, macroeconomic factors, etc.
  2. External reference rates
    1. Defined as reference rates published by the FBIL or the repo rate governed by the RBI
    2. Depends on macroeconomic factors and position of Indian government and RBI

Are home loans linked to an external reference better?

While both internal and external referral-linked home loans have their advantages, external referral-linked home loans home loans offer two key benefits that are crucial for all long-term borrowers.

Transparency in the pricing mechanism

With home loans linked to an internal reference, the interest rate is changed at the sole discretion of the lender. For example, even in a favorable market scenario, the lender may not choose to lower your interest rate.

On the other hand, external benchmarks are regulated and you get full transparency – on how these rates are derived and when they are changed by the governing body. Plus, they’re reviewed at predetermined intervals, letting you know when they might change.

Faster transmission of the interest rate advantage

With home loans indexed to internal benchmarks, the transmission of profit is subjective. On the other hand, with external indexed home loans, the benefit is passed on to you more quickly. For example, when the benchmark rate changes, your interest rate is usually reset on the next payment due.

Choosing between an HFC and a bank

Typically, with a specific lender type, you are limited to a specific referral type. On the one hand, banks are mandated by the RBI to link mortgage interest rates to external benchmarks. On the other hand, HFCs are free to link their home loan interest rates to internal or external benchmark rates. However, most HFCs only offer loans linked to internal referrals.

In addition, within a loan category, banks must adopt a uniform external benchmark – in other words, banks cannot have different benchmarks within the same loan category. For example, for retail loans, a given bank must link all home loans to a single benchmark, such as the repo rate.

HFCs do not have this constraint and can choose to offer different benchmarks within a given loan category. For example, Bajaj Housing Finance is the first and only HFC with which one can either avail a home loan linked to the RBI repo rate or the lender’s internal benchmark, FRR.

Home loans indexed to the pension rate

When you get a pension rate linked home loan, whether from a bank or an HFC such as Bajaj Housing Finance, you benefit from transparency and faster transmission of benefits, as with any other external reference linked loan.

  • The RBI convenes a meeting of the monetary policy committee every 2 months, when it decides on any changes in key rates, such as the repo rate. The exact rate change is reflected in your interest rate. For example, if the repo rate decreases by 0.25%, your interest rate linked to the repo rate will also decrease by 0.25%.
  • When the RBI changes the repo rate, your interest rate is revised based on the guidelines set by the lender – which could be the next loan maturity date or the 1st upcoming quarter day

Apply for a repo rate linked home loan from Bajaj Housing Finance today. With minimal documentation, a repayment term of up to 30 years, and the most favorable borrowing terms on over 5,000 approved projects, you are assured of a hassle-free lending experience. Interest rates start at 6.65%* per year for salaried and professional mortgage applicants.

*Terms and conditions of application*

This is a partnership position.

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