Hike in repo rate: How to modify loan instalments

– Vinod Kothari | finserv@vinodkothari.com

Based on the decision on the Monetary Policy Committee[1], the RBI, on 5^th August, 2022, hiked the repo rate by 50 bps, to 5.4%. This brings the policy rate to the level where it was before the Pandemic (a brief time chart of the repo rate may be referred below). Thus, while the impact of COVID-19 may still be long and persisting, but the COVID-19 reliefs are all gone.

The increase in interest rates was widely expected, and therefore, is not a matter of shock. Nevertheless, lenders whose loans are based on fixed monthly instalments will now be required to pass on the burden of higher interest rates to their borrowers. The other option, of course, is for the lender is to absorb the burden on one’s own interest margins. This may be a cautious call, because the collection efficiency remains fragile, and any increase in interest rates may have significant adverse impact on borrower behaviour. Therefore, lenders may need to choose between compressed net interest margins, and delinquent borrower behaviour.

If an NBFC decides to pass on the interest rate increase to borrowers, it may broadly have 4 options:

• Keep EMIs the same, and extend the tenure
• Keep tenure the same, and increase the EMIs
• Keep both tenure and EMIs the same, and have an adjustment with the last of the EMIs, to recover the increased interest cost
• Have a staggered impact on EMIs, such that the increase in EMIs immediately is lower, and catches up over time.

The idea, in each case, is to maintain an effective interest rate which is higher by the same basis points (bps) by which reference interest rate has been revised, say, 50 bps. In fact, most lenders do not directly relate their base lending rates to repo rates – instead, they have base lending rates.

Choosing either of the 4 options above requires careful analysis of the impact on the borrower behaviour. Besides, which of these options will be available to a lender will also depend on the provisions of the loan agreement.

Keeping EMIs constant, and increasing the tenure, is one that is widely regarded as borrower friendly. The borrower’s debt servicing burden every month does not increase – therefore, the affordability of the loan remains intact. However, in case of longer tenure loans such as home loans, increasing the tenure may take the maturity to a time zone where the borrower’s age will cross his expected retirement age, and therefore, result into back-heavy risk of default.

On the other hand, reflecting the interest rate into EMIs immediately has an instant impact on borrower behaviour. Clearly, the borrower’s disposable income would not have gone up as the EMIs went up, creating a squeeze on this debt servicing ability. Particularly in cases where the EMIs are a high proportion of the disposable income (usually anything above 35 -40% is considered high, but this has to do with the income levels), there may be immediate impact on default behaviour.

The ballooning of the burden of interest rate change (that is, taking it to the end of the loan term) seems possible only in case of asset-backed loans, where the value of the asset remains strong. For instance, this is something that may be tried in case of home loans. However, where the asset depletes fast, creating a back-heavy payment is only deferral of the default.

Staggered EMI increase seems to be a feasible solution, though it is computationally intensive, and difficult to explain to borrowers.

The next question that may arise is on the implementation aspect- will the increase in EMIs or extension of tenure require any addendum or supplementary documentation to be executed by the borrower? Since there would be a change in the repayment schedule of the borrower, the same must be duly communicated to the borrower as well. Most of the loan agreements provide the right to the lender to prospectively change the interest rates due to change in the base lending rate. Hence, lenders are required to give notice to the borrower in the vernacular language or a language as understood by the borrower, about the prospective change in the interest rates and subsequent change in repayment schedule.

Based on the discussion above, in cases where there is a change in the borrowing rate of the lender, it is for the lender to decide whether it intends to pass on the burden of higher interest rates to their borrowers or absorb the burden on one’s own interest margins. The latter case must be evaluated against the definition of ‘restructuring’ provided in Paragraph 1 of the Annex to the Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions 2019, dated June 7, 2019[2]. As per the definition provided therein-

Restructuring is an act in which a lender, for economic or legal reasons relating to the borrower’s financial difficulty, grants concessions to the borrower. Restructuring may involve modification of terms of the advances / securities, which would generally include, among others, alteration of payment period / payable amount / the amount of instalments / rate of interest; roll over of credit facilities; sanction of additional credit facility/ release of additional funds for an account in default to aid curing of default / enhancement of existing credit limits; compromise settlements where time for payment of settlement amount exceeds three months.

Based on the aforesaid definition, it is clear that restructuring would mean that there are changes in existing terms of repayment which is triggered due to the financial status of the borrower, that is to say, owing to the stress in borrower’s repayment abilities some sort of concession or relief is being granted to the borrower. Further, this would mean that the existing terms of the loan are being altered to provide some relief to the borrower. However, not passing on the burden of higher interest rate to certain borrowers would not have any impact on the existing repayment terms of the borrower. Hence, the same should not be considered as restructuring. Further, in case a lender intends to pass on the interest burden to selective customers only, the same should be based on certain criteria and not be discriminatory.

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=54148

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11580&Mode=0