The Reserve Bank of India (RBI) a few days ago extended the deadline to another six months (till June 30 2011) to adopt the new method for computing base rate. Base rate is not very different from the PLR. However, it will be reflective of the current rates as RBI requires that the base rate be revised on a quarterly basis. Hence, any change in the interest rates will be passed on to borrowers latest in 3 months time. Also, banks are not allowed to lend below the base rates.
The Reserve Bank of India (RBI) a few days ago gave banks another six months till June 30 2011 to adopt the new method for computing base rate — below which lenders are not allowed to extend loans.
Some banks have already transitioned from the PLR to a new ‘Base Rate’ system for interest rates on loans. What does this change imply? How will it impact your existing loans?
Till very recently banks used the PLR or Prime Lending Rate as a basis to decide the interest rate on its home loans as well as other loans. In order to understand the change and its impact, it is important that you understand what the PLR means. PLR is the rate computed by banks based on the costs of funds to them. Banks used PLR to determine the rates at which it would lend its funds, be it for home loans or any other loans such as car loans, personal loans etc. The idea was to ensure that the banks do not suffer losses by lending out money at a rate lower than the cost of acquiring it.
Banks generally gave loans at PLR plus certain basis points. (100 basis points is equivalent to 1.0 percent). So, if your loan document said that interest would be PLR plus 300 basis points and the Bank’s PLR is 10 percent, your interest rate would be 13 percent.
Over time PLR had become redundant. This is mainly because it was not updated to reflect the changes in the costs of borrowing funds. So, if the interest rate on FDs was reduced, the corresponding PLR was not changed to reflect the decrease, hence borrowers continued to pay the high interest rates.
Lately, banks started lending funds at rates below the PLR (for example, PLR minus 100 basis points) in order to attract borrowers. Due to such practices the PLR lost its significance. Hence From 1st July, 2010, RBI has decided that the banks should transition to a new Base Rate system.
Why will the base rate work?
Base rate is not very different from the PLR. However, it will be reflective of the current rates as RBI requires that the base rate be revised on a quarterly basis. Hence, any change in the interest rates will be passed on to borrowers latest in 3 months time. Also, banks are not allowed to lend below the base rates.
Impact on existing loan holders / borrowers
At present, there is no major impact on existing borrowers. This is because; most banks have kept their interest rates unchanged. For example, SBI has kept its base rate 8 percent and HDFC Bank retains its rate at 7.25 percent. Where the base rate is altered, banks are adjusting the margin or basis points so that the borrower continues to pay the same interest rate. Say the interest rate on a loan was PLR plus 100 base points for a PLR of 9 percent. If the bank’s base rate is 8 percent, the interest rate charged to the borrower will now be ‘base rate plus 200 basis points’.
Further, customers can switch their loans to the base rate system without any fees or other charges. So, if you wish to change your loans to the new system, you can do it without any additional costs. Note that borrowers can continue their existing loans on the PLR system too.
Should you switch to the base rate?
Even though the base rate is unlikely to have an immediate impact, it has the potential of significantly reducing your outflow if the interest rates are reduced in the future. This is because, the base rate will be revised every quarter and when interest rates fall, your loan rate will also go down. If you are charged a floating interest rate this change is a significant one for you. Further, if you have taken loan recently, the impact is considerable since a large part of the EMI is used towards interest payment in the initial years of repayment of the loan.
Let us take an example to understand the impact of decrease in interest rates under the PLR and Base Rate systems. Assuming that your home loan is for Rs. 25L for 10 years @ 10 percent p.a. Interest rate is PLR plus 200 basis points.
Case 1: PLR is 8 percent at the time of taking the loan. After two years, the interest rates decline but PLR is not revised.
| Year | Starting Balance | Interest Repaid | Principal Repaid | Ending Balance |
| 1 | 25L | 2.43L | 1.53L | 23.47L |
| 2 | 23.47L | 2.27L | 1.69L | 21.77L |
| 3 | 21.77L | 2.09L | 1.87L | 19.90L |
| 4 | 19.90L | 1.90L | 2.07L | 17.83L |
| 5 | 17.83L | 1.68L | 2.28L | 15.55L |
| 6 | 15.55L | 1.44L | 2.52L | 13.03L |
| 7 | 13.03L | 1.18L | 2.79L | 10.24L |
| 8 | 10.24L | 0.89L | 3.08L | 7.16L |
| 9 | 7.16L | 0.56L | 3.40L | 3.76L |
| 10 | 3.76L | 0.21L | 3.75L | NIL |
Figures in Indian Rupees
Total Interest paid using the PLR: Rs. 14.65L
Case 2: Using Base Rate System. The base rate at the time of taking the loan is 8 percent. It is reduced to 7.0 percent after 2 years. So, the interest rate on the loan is revised to 9.0 percent.
| Year | Starting Balance | Interest Repaid | Principal Repaid | Ending Balance |
| 1 | 25L | 2.43L | 1.53L | 23.47L |
| 2 | 23.47L | 2.27L | 1.69L | 21.77L |
| 3 | 21.77L | 1.88L | 1.95L | 19.82L |
| 4 | 19.82L | 1.70L | 2.13L | 17.69L |
| 5 | 17.69L | 1.50L | 2.33L | 15.36L |
| 6 | 15.36L | 1.28L | 2.54L | 12.82L |
| 7 | 12.82L | 1.04L | 2.79L | 10.03L |
| 8 | 10.03L | 0.78L | 3.05L | 6.98L |
| 9 | 6.98L | 0.49L | 3.33L | 3.65L |
| 10 | 3.65L | 0.18L | 3.65L |
Figures in Indian Rupees
Total Interest paid using the base rate: Rs. 13.55L
Therefore, your total saving on interest payment under the base rate method will be Rs. 1.10L.
Limitations
The base rate for each bank is different and banks have the liberty to determine their base rates. Further the banks can influence the interest rates charged on loans by altering the basis points too. For example, even if the current base rate may be lower than PLR, most banks have kept their interest rates on loans the same by adjusting the basis points or margin money. Hence the benefit of lower base rate has not trickled down to borrowers.