FAQs on Reset of Floating Interest Rate on Equated Monthly Instalments (EMI) based Personal Loans

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On August 18, 2023, the RBI came up with a circular on Reset of Floating Interest Rate on Equated Monthly Instalments (EMI) based Personal Loans (‘Circular) casting certain obligations and disclosure requirements on Regulated Entities (REs) at the time of reset of floating interest rate on EMI based Personal loans. Accordingly, this Circular shall be adhered to by all applicable entities at the time of reset of floating interest rate on such loans.

We have developed a set of FAQs on the Circular, where we intend to answer some of the critical questions relating to the actionables by the REs at the time of reset of floating rate. 

Further, our detailed article on this topic can be read here – RBI streamlines floating rate reset for EMI-based personal loans

Table of Contents:

Applicability and Coverage

Options with the borrower

Prepayment Option

Prepayment Option

Fixed rate option

Board-approved Policy

Disclosure and Communication

Applicability and Coverage

1. Which entities are covered by the Circular?

Response: The Circular covers: 

• All Scheduled Commercial Banks
• Regional Rural Banks
• Primary (Urban) Co-operative Banks
• State Co-operative Banks and District Central Co-operative Banks
• Non-Banking Financial Companies
• Housing finance Companies 

2. Which type of loans are covered by the Circular?

Response: The Circular covers all EMI-based floating interest rate personal loans. Accordingly, business loans are not covered by the circular. 

Further, if the loan carries a fixed rate of interest, it does not come under the Circular. 

If the loan is not based on EMIs, that is, it is a bullet repayment loan, it does not seem to be covered by the Circular.

The table below states the applicability of the Circular on certain types of loans – 

Covered by the Circular	Not covered by the Circular
Home loans at floating rate of interest	Home loan at fixed rate of interest
LAP to individuals other than for business purposes	LAP  given to an individual/sole proprietor
Auto loans having rate variation clause	Auto loans not having rate variation clause
Student loans having rate variation clause, whether with or without moratorium	Fixed rate student loans
	Loans against shares
	Financial leases

3. A loan is based on EMIs, but is currently under a moratorium. Will it be covered by the Circular?

Response: Yes, in our view. The EMIs are subjected to either variation, or the term may be modified based on interest rate changes. Hence, the Circular applies.

4. A loan is based on EMIs, but has a partial balloon repayment. Will it be covered by the Circular?

Response: In our view, yes.

5. My company follows a different approach to interest rate variation. Neither do we increase the EMI, nor do we extend or contract the maturity based on interest rate changes. Instead, we add the impact of interest rate changes to a terminal amount, which either goes up or comes down based on interest rate changes. In a way, the last “unequal installment” reflects all interest rate changes during the period. Are we covered by the Circular?

Response: In our view, yes. The burden or benefit of interest rate changes is being passed on. The applicability of the Circular is not dependent on the way the burden or interest is being passed on, instead it shall cover all floating interest rate personal loans. Hence, the Circular does apply in the present case.

6. What type of loans are covered under “personal loans”?

Response: The Circular gives reference to the RBI circular on XBRL Returns – Harmonization of Banking Statistics which defines personal loans as-

“loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).”

 Further, “Consumer Credit” has been again defined as-

 “loans given to individuals, which consists of (a) loans for consumer durables, (b) credit card receivables, (c) auto loans (other than loans for commercial use), (d) personal loans secured by gold, gold jewellery, immovable property, fixed deposits (including FCNR(B)), shares and bonds, etc., (other than for business / commercial purposes), (e) personal loans to professionals (excluding loans for business purposes), and (f) loans given for other consumptions purposes (e.g., social ceremonies, etc.). However, it excludes (a) education loans, (b) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), (c) loans given for investment in financial assets (shares, debentures, etc.), and (d) consumption loans given to farmers under KCC. For risk weighting purposes under the Capital Adequacy Framework, the extant regulatory guidelines will be applicable.”

7. Does the Circular cover Loans Against Property?

Response: There is no end use restriction in case of Loan Against Property or LAP. In case the same is extended to an individual it may or may not be for personal use. In such a case, if it is given to individuals for purposes other than business then it will be covered by the Circular.

However, in case it has been extended to non-individuals, such as SMEs or small businesses, it can be presumed that the primary use of the loan proceeds shall be for business purposes and therefore it will not be covered by the Circular.

8. Are we saying any lending to companies is outside the scope of the Circular?

Response: Yes, in our view, the intent is to cover only personal loans to individuals- more specifically, EMI based floating rate personal loans. Since, it would be counter intuitive to say that the loan given to companies would be for personal use, the same may not be covered under the Circular.

9. Are auto loans covered by the circular too ?

Response: Yes, the definition of the term consumer credit includes auto loans as well and therefore the same will be covered by the circular. Accordingly, all auto loans having a rate variation clause are covered by the circular. 

10. Are loans given to SMEs covered?

Response: As discussed previously, business loans are not covered by the Circular. Accordingly, SME loans do not fall within the ambit of this Circular. 

11. Does the circular extend to micro-finance loans as well?

Response: Yes. Microfinance loans as defined in the RBI Master Direction for Microfinance Loans, 2022 states that all collateral-free loans, irrespective of end use and mode of application/ processing/ disbursal (either through physical or digital channels), provided to low-income households, i.e., households having annual income up to ₹3,00,000, shall be considered as microfinance loans.

Accordingly, the microfinance loans fall within the ambit of the Circular in case they are extended at a floating rate.

12. Are digital loans covered by the Circular?

Response: Yes, EMI based floating rate digital loans are also covered by the Circular. 

Options with the borrower

13. In case of reset in the floating interest rate, what are the options that have to be given to the borrower?

Response: The Circular provides for a number of options which should be given to the borrower in the event of reset of the floating rate of interest. These are – 

• Enhancement/ reduction in EMI 
• Elongation/ contraction  of tenor
• Combination of both options
• Prepayment in part 
• Prepayment in full 
• Switching from floating rate to fixed rate 

14. In case the borrower does not exercise any option then can the REs provide a default option?

Response: Yes, REs may put in place a default option which will be automatically exercised in case the borrower does not communicate his choice to the lender within a reasonable time given to him. In most cases, this default option is an elongation of the loan tenor. Ideally, this default option should also be communicated to the borrowers. 

15. Let’s assume, the fixed interest rate at the time of sanctioning the loan was 14%. Now at the time of change in the floating rate of interest, the borrower exercises the option to convert his floating rate loan to a fixed interest rate loan. In such a case, are the REs required to charge the fixed rate of 14% or can they charge a higher rate ?

Response: REs are not obligated to charge the same fixed rate of interest which was prevailing at the time of sanctioning of the loan.   

16. How many times can a switch from floating to fixed rate and vice versa take place during the tenor of the loan ?

Response: While the Circular itself does not specify the number of times such a switch is allowed during the tenor of the loan it states that the board approved policy framed may specify the same. Accordingly, the number of times such a switch may happen during the tenor of the loan will be governed by the respective policies of the REs.. 

17. What is negative amortization ?

Response: Negative amortization refers to a situation where the scheduled payments on a loan are insufficient to cover the interest costs. As a result, the unpaid interest gets added to the loan’s principal balance. This leads to the loan balance increasing over time, rather than decreasing as it would with regular amortization.

18. What is the external benchmark lending rate ?

Response: As per the RBI circular on External Benchmark Based Lending the base rate of the floating interest rate loans should is benchmarked to any one of the following:

• Reserve Bank of India policy repo rate
• Government of India 3-Months Treasury Bill yield published by the Financial Benchmarks India Private Ltd (FBIL)
• Government of India 6-Months Treasury Bill yield published by the FBIL
• Any other benchmark market interest rate published by the FBIL.

The Circular covers all loans linked to an external benchmark rate and in case of any reset in the floating interest rate with respect to such loans, the Circular becomes applicable. 

Prepayment Option

19. Are we saying prepayment option has to be given to a borrower at every stage of a loan?

Response: Usually the prepayment option is provided to the borrower, with or without certain caveats such as exercising the option post the initial lock-in period or levy of prepayment penalty, to the extent permissible, etc. The Circular provides to specifically provide this option at the time of reset of the floating interest rate. This option would be in addition to the prepayment option provided to the borrower as per the loan terms.

20. Are we saying a partial prepayment option has to be given to the borrower at every stage of a loan? Can the lender fix a minimum partial prepayment size? How large can such partial prepayment size be?

Response: As discussed above, the partial prepayment option at any time of the loan shall be as per the agreed loan terms, that is with minimum size etc. However, the option at the time of reset should not be restricted and the borrower shall be allowed to partially prepay at its discretion.

21. What is the position about prepayment penalties?

Response: The Circular states that in case the borrower exercises the option to prepay the loan either in full or in part, the prepayment penalty or foreclosure charges shall be in accordance with the extant guidelines. 

However, levying prepayment penalty in case of floating interest rate loans to individuals for purposes other than business is not allowed both under the RBI Master Direction for NBFCs as well as RBI Master Directions for HFCs. 

22. Can there be a penalty for partial prepayment?

Response: While the situation for charging prepayment penalties remains the same in case of partial prepayment too, as discussed above, charging of such penalties in case of floating interest rate loans to individual borrowers for purposes other than business is not permitted. 

23. Can the lender establish conditions for foreclosure, such as mandating that foreclosures can only occur in a single instance? 

Response: RBI in the circular has recognised partial foreclosure and specified the same as an option to be provided at the time of reset of the floating rate. Therefore, the lender at the time of reset in the  floating rate of interest, has to give the borrower an option to either foreclose the loan in part or in full. However, in other cases, the lender may impose conditions such as the one mentioned in the question. . 

24. Can the lender impose a restriction on the number of partial prepayments during a year?

Response: Considering the operational hassle and to discourage borrowers from frequently exercising the prepayment option, there can be restrictions imposed on the number of partial prepayments during a year. The same must be specified clearly in the loan documentation. 

25. Can the excess amount paid by the borrower at the time of foreclosure be forfeited by the lender? 

Response: Foreclosure should not be declined due to payment of excess amount. 

However, receipt of excess amounts could lead to operational hassles for the lenders, therefore, to discourage the customers for paying excess amounts and claiming refunds, the lender may incorporate a condition in the loan agreement stating that in case the company receives an excess amount at the time of foreclosure of loan, it shall refund the excess amount after deducting the administrative charges.  

26. Can the lender allow foreclosure of the loan only between a specific period of the month, say between 10th to 20th of a month? 

Response: Yes, the same can be done for operational purposes. The lender should clearly specify the same in the loan documentation. 

27. The HFC directions provide that no foreclosure charges can be charged to the borrowers who are closing the loan through their own sources. In this regard can the lender ask for documents to determine the borrowers’ capacity to pay at the time of pre-closure? 

Response: First and foremost, the onus to prove that the prepayment is being done out of owned funds will be on the borrower. However, in order to satisfy itself, the lender may ask for documents evidencing the borrower’s capacity to pay out of its own funds. In this regard, the lender may ask for documents like 2-3 months’ bank statements or other documents which can prove the borrower’s capacity to pay. 

28. Can the lender impose a condition restricting part-payment and foreclosure for an initial period of 12 months?

Response: In case of a reset in the floating rate of interest such a condition cannot be imposed and the lender has to allow foreclosure of the loan even during the initial period of 12 months. 

In other cases, however, the lender may specify an initial period during which prepayment of loans shall not be allowed.

29. In case of partial prepayment, does the borrower have the option of (a) reducing EMIs every month, keeping the tenure the same, or (b) contracting the tenure?

Response: In our view, EMIs are fixed based on the affordability and the debt-to-income ratio of the borrower. If the loan size gets curtailed due to partial prepayment, reducing the EMIs seems an unreasonable request. We are of the view that if the lender does not agree to reducing the EMIs, and gives effect of the reduced principal on the remaining term, the same is reasonable.

Fixed rate option

30. Are we saying a fixed rate option has to be given to the borrower at every stage of the loan, or is it only at the time of a variation of interest rates?

Response: If the regulations are expecting a switch-over option at the time of an interest rate variation, the same has no meaning unless there is a fixed rate option for a new loan at the time of switch-over. We are of the view that lenders will have to parallelly offer a floating rate option and an equivalent fixed rate option.

31. Are we expecting a lender to disclose to the borrower what the fixed rate will be, in case of a variation of interest rates?

Response: This is counter-intuitive. The fixed rate at the time of interest variation will be the fixed rate that corresponds to the revised variable rate at the time of variation.

32. How does one arrive at a fixed rate corresponding to a floating rate loan?

Response: The pricing of a fixed rate loan factors the interest rate variation risk, as the only differentiator between a floating rate loan and fixed rate loan is the interest rate risk. In the case of a floating rate loan, the risk is transmitted to the borrower; in case of a fixed rate loan, the risk is taken by the lender. Hence, the lender has to price the interest rate variation risk.

The approach may be the same as the cost of an interest rate swap (IRS), that is, the fixed rate cashflows for a floating rate loan. There is a significant difference between an IRS and the pricing of a fixed rate loan. In the IRS, the notional value remains the same all through; in case of a home loan, the POS continues to amortize. However, that difference may not matter, as the rates are applied in either case on the notional value/ POS value. The other difference is the ability to prepay the loan which does not exist in case of an IRS. These nuances apart, the pricing may follow the same underlying logic.

In practice most home lenders price a fixed rate loan at the higher end of the yield curve for the remaining term of the loan. The slope of the yield curve captures the potential future changes in interest rates.

A borrower switching from a floating rate to a fixed rate loan protects himself from further changes; at the same time, deprives himself of the benefit of any rate reduction thereafter.

32A. Can a lender provide an option to a borrower to switch from floating to fixed and vice versa, and if yes, then how fixed rate can be switched into floating rate

Response: The position of a fixed rate loan getting converted into a floating rate loan is the same as that of prepayment of a fixed rate loan. When a fixed rate loan is prepaid, the lender loses the fixed rate of interest, and assuming that the money will now get invested at the-then prevailing rate, the lender will earn at the prevailing rate. When a fixed rate loan is swapped against a floating rate, even though there is no prepayment, the position is similar. As in the case of prepayment, the borrower will do the switchover only where he expects the interest rates to come down.

Fixed rate loans carry a mark-to-market gain when interest rates have moved down (the gain is not brought into books at loans are mostly carried at amortised cost, except where they fail the “business model of holding the loans” test. As floating rates are repriced based on market rates, they cannot carry any mark-to-market gains, except for the difference between the underlying base rate, or the credit risk premium.

The relationship between fixed rate and floating rate at any time is driven by the slope of the yield curve. If the yield curve is showing a downward slope, it is quite logical that the fixed rate option is cheaper than the floating rate. That itself will be a disincentive for the borrower to move from fixed rate to floating rate. In addition, the lender may charge a penalty (switchover charge) for choosing to move to floating rate, and this switchover charge may be priced based on the mark-to-market gain lost by the lender.

32B. If fixed rate is allowed to switch into floating then can the lender charge switching fees? How will the same be computed?

Response: Para 2(iv) of the circular states that “all applicable charges for switching of 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.”

In our view, what can transparently be disclosed is the computation of the switchover charges, as the actual charge is based on the mark-to-market gain inherent in the fixed rate loan at the relevant time.

Board-approved Policy

33. The REs are advised to put in place a board approved policy for the reset of floating interest rate on EMI based personal loans. What will be the contents of this policy ? 

Response: The policy should at minimum cover the following:  

• Options to extend to customers;
• Maximum allowable frequency for borrowers to switch between floating and fixed rate loans;
• Applicable charges related to the provided borrower options.

Disclosure and Communication

34. Are the REs required to send a statement to the borrowers every quarter ?

Response: The Circular states that REs shall share / make accessible to the borrowers, through appropriate channels, a statement at the end of each quarter. 

Accordingly, if the borrowers have access to this quarterly statement, the same is in sufficient compliance with the provisions of the Circular and there is no requirement of sending such statements to the borrower every quarter.  

35. What are the contents of this quarterly statement ?

Response: The quarterly statement should at the minimum state – 

• Principal and interest recovered till date
• EMI amount
• Number of EMIs remaining
• Annualized rate of interest / Annual Percentage Rate (APR) for the entire tenor of the loan.

36. In case of loans other than floating interest rate loans, is there a requirement to send/make accessible such a statement every quarter to the borrowers ?

Response: The Circular extends to only EMI based floating interest rate personal loans. Therefore, this requirement of sending/making accessible a quarterly statement to the borrower does not extend to other types of loans. The same would be sent as per the internal policy of the lender.

37. The Circular is applicable from 31st December 2023. Are the REs required to intimate the borrowers of the various options available to them in the event of change in the floating rate of interest before such date ?

Response: The Circular covers both existing and new loans. Accordingly, all applicable entities are required to intimate the borrowers on or before 31st December 2023, the options available to them in the event of reset of floating interest rate.