It is commonly believed that if Banks are offering you the home loan at 12% means it is the total interest they will collect and calculate on your loan. But it is not like that. Your interest on loan consists of two parts. One is Base Rate and another part is Spread. So let us look at each part and how each can affect your EMI.
1) Base Rate:-It is the new system of setting bank’s basic interest rate which was started from 1st July 2010. It replaced the old method of charging Benchmark Prime Lending Rate (BPLR). In simple words you may say that it is the minimum rate, below which Banks cant give you loan (exceptions are Agricultural Loan and Export Credit). It is reviewed on quarterly base. But it is not mandatory that all banks must have same base rate. Advantage of Base Rate over BPLR is transparency. It is calculated considering the below factors. But highest weightage is given to Cost of Deposits.
A) Cost of Deposits, B) Negative carry on CRR and SLR, C) Unallocatable overhead costs, D) Average Return on Networth.
It is the benchmark for all floating rate loans except loans which have tenure of one year. RBI not made it mandatory to follow Base Rate for loans of below one year. But for this sub Base Rate loans too RBI put some strict ceilings.
2) Spread-This is your final rate of interest after adding some % to Base Rate. It is calculated based on the tenure risk, credit loss, profit requirement of bank, operating cost of the bank and risk assigned with individual customer. So each bank’s Base rate may be fixed for all customers. But remember that you may end up with either paying high interest rate or low based on the spread bank charges to each individual. Their is no cap on how much should be spread on and above Base Rate. But charged spread need to be justifiable. Hence your banks may use this tool to charge you more by modifying spread as no regulation on this. Eventhough RBI says spread must be constant over the period of loan but remember to check it whenever the raise in your loan EMI. You need to verify whether the raise in EMI is due to hike in Base Rate or Spread.
Hence while looking for loans always better to check two things from your bank, what is their base rate and spread rate. Also the guidelines Banks follow to calculate the spread and how often the possibility of change in spread. I am clarifying that even though base rate and spread are the part of other type of loans too, I wrote this post concentrating on home loan and car loan.