How Is the Interest Rate on a Loan Determined?

The interest rate on a loan generally consists of two components:

Loan interest rate = Benchmark + Spread

The benchmark is the reference rate used to price the loan. It may be an external rate, such as the RBI repo rate, Treasury Bill yield or Secured Overnight Rupee Rate (SORR), or an internal rate such as the Marginal Cost of Funds-based Lending Rate (MCLR). The spread is added over the benchmark and may cover credit risk, operating costs, loan tenure and the lender's business strategy.

For example, if the benchmark is 6% and the spread is 2.25%, the borrower's interest rate will be 8.25%.

Note: The rates and figures used in the example are for illustration purposes only. Actual benchmark rates, spreads and loan interest rates may vary depending on the lender, loan type and applicable terms.

Which Loans Would Be Linked to an External Benchmark?

Under the proposed draft, commercial banks would have to link all floating-rate personal loans and floating-rate MSME loans to an external benchmark. Commercial banks could also offer external benchmark-linked loans to other borrowers. The requirement would not be compulsory for NBFCs, housing finance companies, regional rural banks, co-operative banks and all-India financial institutions, which could decide whether to offer them.

When Would Borrower Consent Be Required?

All existing loans linked to an internal or external benchmark would have to be migrated to the proposed interest-rate framework by 1 April 2029. The lender would complete a one-time mapping exercise with the borrower's consent.

It also provides three protections:

• The revised interest rate cannot exceed the rate applicable immediately before migration
• The borrower cannot be placed at a disadvantage regarding the applicable interest rate
• The lender cannot charge a fee for the migration

For example, if an existing loan carries an interest rate of 8.5% immediately before migration, the lender cannot move it to the new framework at 8.75%. This consent applies to the transition, not every movement in the existing benchmark.

Will Banks Need Consent for Every Interest-Rate Reset?

If a home loan is linked to the RBI repo rate, the lender may revise the loan rate on the scheduled reset date when the repo rate changes. Fresh consent would not normally be required because the reset mechanism forms part of the agreement.

The draft proposes that the agreement must clearly specify:

• The benchmark used to price the loan
• The frequency of the reset
• The date on which the reset will take place

The reset interval for floating-rate loans generally cannot exceed three months. Once the frequency has been fixed for a loan, it must remain unchanged throughout the loan tenure. Certain smaller lenders would be exempt from this requirement.

What Happens If a Benchmark Is Discontinued?

If a benchmark is discontinued during the loan tenure, the proposed draft permits the lender to replace it without placing the borrower at a disadvantage regarding the applicable interest rate. The agreement may contain a fallback mechanism for this situation. Unlike the one-time migration of existing loans, the draft does not expressly require separate borrower consent when a discontinued benchmark is replaced.

What Could Happen to Your EMI?

The one-time migration should not increase the borrower's interest rate because the revised rate cannot exceed the rate applicable immediately before the transition.

Depending on the resulting rate and repayment process:

• The EMI may remain unchanged
• The EMI may decrease
• The remaining loan tenure may become shorter
• The lender may adjust both the EMI and tenure

After migration, benchmark movements can still affect the loan rate. If the benchmark rises, the lender may increase the EMI, extend the tenure or adjust both. If it falls, the EMI may reduce or the loan may be repaid earlier, depending on the agreement and selected repayment option.

What Other Changes Have Been Proposed?

The wider framework also proposes that:

• Interest must be calculated on a daily reducing-balance basis
• Lenders must use the actual number of days for interest calculations
• Internal benchmark methodologies must be publicly disclosed
• Lenders must have board-approved loan-pricing policies
• An APR ceiling must be set for microfinance and personal loans of up to ₹50,000
• Interest and charges on certain short-term agricultural loans cannot exceed the principal amount

Final Thoughts

The RBI proposed draft aims to make loan pricing more consistent and transparent. Borrower consent would be required when existing loans are migrated, but not for every ordinary floating-rate reset.

The immediate migration cannot increase the applicable interest rate. Future benchmark movements may still affect the EMI or remaining tenure. Since the directions are still in draft form, borrowers should wait for the final RBI notification before treating these provisions as effective rules.

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