Determinants of interest rates
Taking a home loan entails contracting a significant long term liability for the borrower in the form of monthly installments (EMIs) for a fixed tenure. Any increase in home loan interest rates increases the burden of debt servicing for the borrower as reflected in an increase in EMI or as in increase in tenure. Hence, it becomes pertinent that a home loan borrower understands the factors that determine the home loan interest rates.
Read more: Loan Eligibility Calculator – Home Loan, Loan Against Property Online
A bank will charge an interest rate which is higher than its overall cost of funds. Hence, understanding the key component of cost of funds for a bank is critical in assessing the structure and likely quantum of interest rates. Cost of funds for a home loan provider is dependent on the following factors:
- Repo rates as fixed by RBI and announced in quarterly monetary policy: The Repo Rate announced by RBI is the single most important parameter that determines the cost of funds for banks. Repo rate is the rate at which RBI provides short term loans to banks. Any increase in Repo rates by RBI typically leads to banks increasing the interest rates for their borrowers, including home loan customers.
- Regulatory Cost determined by RBI’s monetary policy: In addition to repo rates, RBI uses CRR (Cash Reserve Ratios) to manage the liquidity in the financial system and regulate the rate of inflation in the economy. CRR represent the minimum % of cash balances that banks are mandated to maintain as a % of their total liabilities. Cash balances carry zero interest rates and hence, a higher CRR translate into higher cost of funds for a bank.
- Quantum of CASA (Current Deposits account and Savings Deposits account) deposits for a bank: Current Deposits with a 0% interest and Saving Deposit with a 4% interest rate typically entail a significantly lower interest expenses for banks as compared to Time Deposits with interest rates as high as 8-9%. Further, CASA funds carry a fixed rate of interest and are relatively stable source of funds for a bank. Hence, banks with a high level of CASA as a % of their total deposits will typically have low cost of funds and would be able to lend at lower interest rates.
There are other components that get added to banks cost of funds for calculating home loan interest rates. These components include a bank’s cost of operations (which include expenses such as salary costs, distribution and marketing costs, technology costs etc.) and a credit risk premium which the bank charges to cover the risk of default from a certain % of its borrowers. The credit risk premium is a function of the underlying collateral (which in the case of home loans is the residential property owned or being purchased by the borrower) and an assessment of the credit profile of the borrower.
Credit profile of the borrower is dependent on the occupation (self-employed vs. salaried), income and expenditure level of the borrower and past repayment track record of the borrower. Finally, the bank adds its profit margin to calculate its home loan interest rate i.e. the rate at which it will give home loans to its customers.
In essence, the home loan interest rate has a multi-layered structure and is influenced by multiple factors. It would be beneficial and hence, advisable for a home loan borrower to be able to understand and analyse the likely impact of each factor on their cost of borrowing i.e. rate of interest on their home loan.
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