Rising interest rates: Is there a worry of defaults?

On June 16, 2011 in its mid quarter policy review, RBI again hiked its basis points by 25bps. The past 18-20 months have seen a frenzied action in the interest rate scenario. Even with the RBI trying to fight inflation tooth and nail by increasing rates on one front, on another front every bank and financial institution has been passing on the burden of this interest hike almost directly to the borrower. This in effect means that some customers are being charged more that 2-3% than what they were paying in 2009.

Therefore, a higher interest rate would mean that customers have to pay more out of their pocket towards servicing their loan. With most borrowers, living on a paycheck to pay check lifestyle this extra burden is bound to tighten their cash flow. This could in turn prompt them to default. On the other hand, will it actually? The answer is No. Interest rate hikes resulting in increase in defaults is a farfetched idea. Here’s why…

Lenders follow two different types of strategies to implement the interest rate hikes-

1. Increase the tenure of the loan by a few months/years

2. Increase the monthly EMI of the customer to reflect the new rates

In practice, most lenders implement interest rate hikes by using the first method. This preference is for three reasons:

1. Is more hassle free in terms of administrative changes and related paperwork. All that the lender has to do is send a letter stating an increase in the number of EMIs and things continue as they are.

2. An increased tenure will also mean that the lender gets the benefit of higher net interest income as the customer has to pay interest for a longer period.

3. Since customers do not feel the pinch immediately or even in the medium term, there will not be any major complaints or anxieties

Considering the above facts it can be concluded that in cases where the tenure is increased to reflect an increased rate of interest, the chances of customers defaulting is almost nil.

What happens when the interest rate hike is reflected in the EMI?

Although most banks follow the first method, some lenders do follow the second method, especially in scenarios where the borrower’s loan tenure clashes with his retirement age. Even banks, which follow the first method, offer the customer the choice to increase his 
EMI instead of increasing the tenure.

This strategy results in an increased pay out every month for the borrower. Let us understand this using an example.

Christopher took a loan of 25 Lakhs, two years ago at an interest rate of 9.5% PA and for tenure of 15 years (EMI=26,106). Around 6 months ago, his bank sent him a letter stating that his interest rate was being revised to 10.25%. (EMI=27,164). This month his bank sent him a letter stating that his interest rate was being revised by 100 basis points to 11.25% (EMI=28,567).

In a span of two years, his EMI has gone up by Rs. 2461. In the same period, his net take home salary has not increased due to his company freezing salary hikes to tide over the recession. With a new born in the house his monthly expenses have already gone up by over 60% since the period when he first took the loan.

In effect, this extra EMI of 2461 will have to come from another source of income or by borrowing. This month he swiped his credit card for paying the Utility bills to save that cash for paying the extra EMI. However, what about the coming 13 years? This is a strong scenario where Christopher could start defaulting his EMI by not being able to pay on time or the ECS being bounced due to lack of funds. The only solution would be to ask the bank for a higher tenure.

It can be understood that an increased EMI can lead to heavy pressures on personal finance, which in turn could lead to delayed payments and put the name of the borrower in the bank’s defaulters list.

Defaulting a loan consistently

If a borrower defaults a loan consistently for three to six months, the lender will report to Credit Information Bureau India Ltd (CIBIL). This is a central database shared by most of the lenders of the country. If the credit score is poor in CIBIL, there is little chance for a borrower to borrow again from any of the reputed banks and lenders (NBFCs). The score is updated on a regular basis based on the defaults and late payment on loans, higher component of unsecured loans (credit cards, personal loans), higher credit limit utilization on cards and too many loan applications at the same time. 

The score varies from 300 to 900. The higher the score the better is the possibility to get a loan. A bad credit history can ruin the borrower’s credibility and takes a long time to be rectified.

Bottom-line

Although it is always better to go for a higher EMI as against a longer tenure, the borrower must be prudent enough to analyze whether he will be easily able to pay the extra cash outflow. In case his income and expenses are neck to neck, it is better to go for the longer tenure rather than defaulting on the repayments and hurting one’s credit rating.