Home loan rates: the spread counts more than you think

Banks are widening spreads for riskier borrowers, offsetting part of the RBI's rate-cut benefit

- ananya grover

The Reserve Bank of India (RBI) cut the repo rate by 125 basis points to 5.25% through 2025 before shifting to a neutral stance and keeping rates unchanged at its last two policy meetings.

For home-loan borrowers, it should have meant significantly cheaper loans. Yet a closer look suggests many borrowers haven't received the full benefit of the rate cuts. In some cases, borrowing costs have even risen. The reason lies in a less visible component of loan pricing: the spread.

While the repo-linked benchmark moves with RBI policy, the spread is set by banks and varies across borrowers. Understanding how it works can make a difference between assuming you are benefiting from a rate cut and discovering that much of the benefit has been offset by the lender's pricing decisions.

How does it work?

Since October 2019, the RBI has required banks to link floating-rate retail loans to an external benchmark, typically the repo rate. This framework is known as the EBLR.

A borrower's interest rate has two components: the benchmark and a spread. While the benchmark moves with RBI policy, the spread is set by banks based on factors such as credit profile, loan-to-value ratio, operating costs and commercial considerations.

Under the EBLR framework, banks are free to set spreads for new loans. While credit scores and loan-to-value ratios are important, lenders can also factor in broader commercial considerations and customer relationships.

For existing loans, Mukesh Chand, senior counsel, Economic Laws Practice, explained that while RBI guidelines generally provide that the spreads should not be increased during the tenure of the loan, an increase in the credit-risk premium component of the spread may be permissible where there is a significant deterioration in the borrower's credit profile.