In a recent speech on risk management in banks, a RBI Deputy Governor expressed concerns about 'teaser' rate housing loans. The Deputy Governor exhorted banks to ensure that borrowers are well aware of the implications of such rates. Further, credit appraisal has to take into account the repaying capacity of the borrowers when rates become normal, the Deputy Governor said.

The following inferences can be made from the above statement:

a. That the current level of interest rates is not normal

b. That some or even most of the borrowers may not be aware of the implications of such 'teaser' rates

c. That credit appraisals in banks may not be evaluating the repaying capacity of the borrowers on a prospective or forward basis.

One noticeable feature about central bank (RBI) communications exercises in our country - both oral and written - is an implicit belief that all that is inadvisable in the financial markets / system is due to other economic agents such as commercial banks, their borrower constituents and the broader external environment. It would be difficult to find in such (RBI) communications any hint that the central bank's own policy-making framework may also be contributing to any undesirable or unhealthy developments in the financial markets / system. The RBI's concerns about 'teaser' rate home loans seems to be a case in point.

In the circumstances, it would appear that minimising the growth of risky or undesirable financial products such as 'teaser' loans would call for changes not only in how banks do their business. It may also call for fundamental changes in how the RBI conducts monetary and financial markets policy. Such fundamental changes in the RBI's policy-making framework, in turn, could reduce or even eliminate the incentives or rather the compulsions which push commercial banks and their borrowers into products such as 'teaser' rate lending.

What are 'teaser' rates?

'Teaser' rates are interest rates which are designed to entice borrowers to go in for long-term loans but which are not applicable for the entire period of the loan. For instance, a bank may offer a rate of 8 per cent on a 20 year housing loan but will specify that the 8 per cent rate will be applicable only for the first 2 years of the loan. The rate from the 3rd year onwards would be set with reference to the then prevailing market conditions, the bank will say.

The bank will entice the borrower with the 8 per cent rate by pointing out that the 'normal' borrowing rate (which may be applicable for the entire period of the loan) would otherwise be some 13 or 14 per cent.

In fact, it should be pointed out that Indian banks also do not offer housing loans where the rate is fixed or set for the entire loan period. What is "normally" offered (the 13 per cent or 14 per cent referred to above) and what is compared with the 'teaser' rate of 8 per cent is actually the banks' floating lending rate, where the loan rate fluctuates in tune with the changes in the banks' prime lending rate. (This PLR normally changes every 6 to 8 months though the change frequency could be shorter or longer).

Strong appeal of teaser rates...

Extensive studies on borrower psychology and their decision-making approach (even in advanced countries where borrower awareness and information availability is much higher) show that such 'teaser' rates have immediate and strong appeal for them.

Borrowers do not think through how interest rates could evolve over the course of the entire loan period and how that will impact their debt repayment capacity.

(To be sure, forecasting interest rates for the long-term is nearly impossible even for a financial institution, leave alone the individual borrower; what otherwise the borrower can do is to at least look back at history and see how rates have moved over long periods of time; such a past track record will provide some guidance into the future).

Their decision to go in for a long-term financial commitment such as a housing loan is influenced greatly by the fact that the initial rate of 8 per cent keeps their loan repayment commitments manageable in the immediate future.

Indeed, the fact that the immediate repayment commitment will be manageable appeals to a lot of borrowers. It is particularly relevant in India where home ownership is taking off from a low base and consequently millions of people are entering the housing market for the first time. The most noticeable characteristic of such first time home buyers is that their initial incomes / salaries may be quite low and/or they may not be able to put up the 15 or 20 per cent margin which banks demand. The large increase in real estate prices in the past 8/9 years is another major obstacle to home buying. For such first time borrowers, a housing loan product where the initial repayment commitment is 'manageable' and 'low' is really enticing.

It is this market opportunity which commercial banks and other lenders seek to capture by employing the psychological gambit of a 'low' initial teaser rate on a long-term housing loan.

What compels banks to 'tease'?

Banks' recourse to teaser rates on long term loans is not out of choice. In many respects, in fact, they do not have a choice at all. Banks run significant interest rate mis-matches when funding long-term loans such as for housing. In the absence of markets and products where such balance sheet interest rate risks can be hedged, banks do the simplest thing possible: pass on the entire interest rate risk on to the borrowers in the form of floating rate loans. On top of floating rate loans, the 'icing on the cake,' so to say, is the application of the initial low rate to induce the borrower into taking up a long term financial commitment.

In essence, the Indian financial system neither has the long-term funding products (such as long-term bonds/ debentures which can enable banks to, in turn, lend long-term on a fixed rate basis) nor does it have the risk management markets / products where banks hedge the risks of doing long-term lending with (relatively) shorter term funding.

Going beyond these institutional constraints, no lender is also willing to take a call by forecasting interest rates into the future.

Long-term interest rates forecasting sure is no easy task. That is not done even by global central banks such as the US Fed or the Bank of England. Instead, what such central banks have to guide their interest rates decisions and, in turn, provide medium / long-term guidance to the financial system on interest rates is:

a. A policy and conceptual framework based on which their interest rates decisions are made. Such a framework gives due space to operational flexibility and the need to respond to exigencies

b. A clear mandate on some economic goal - such as some rate of increase in prices (inflation) or some rate of economic growth (GDP growth)

c. The framework and the mandate are complemented by a structured and open policy of communication - both verbal and written - and information sharing with the broader financial sector.

In this backdrop, it does not appear that Indian banks can unilaterally take the blame for undertaking 'teaser' rate lending. There are broader systemic issues involved here.

When can ‘teaser’ rates shock?

It is important for borrowers to understand how the initial, welcoming 'teaser' rates on a long term loan can turn into a payment shock and cause financial distress.

Globally, a widely used definition of housing stress is when housing costs (either rent payments or mortgage servicing) exceed 30 per cent of the household income.

In assessing the likely path of the debt servicing ratio in a long term liability, it is important to note that it is the initial years (up to 10 years) that are most significant from the borrowers' perspective. The risks of changing interest rates and how they impact the debt servicing ability is greatest in this initial period.

Simple calculations will show that for a repayment mortgage - that is, where the monthly repayment includes a principal and interest component - of say 20 years, just about 20 per cent of the principal borrowed would have been repaid at the end of 10 years from loan inception. A significant portion of the debt (the principal) will be repaid only after the 10 year period.

The movement of interest rates in the first 10 years of the loan is, therefore, critically important for assessing the debt servicing burden on the borrower. Sharp upward movements in rates could result in a worsening debt service ratio (DSR) as the mortgage payments eat up a rising share of the borrowers' income. Overall reduction in the debt principal also will be insignificant. On the contrary, any notable fall in interest rates could mean the borrower incurring large opportunity losses - if he is not in a position to re-finance the outstanding loan at the going market rates.

Debt-service burden for the borrower

Further, we have considered the 5 year period from May 2004 to mid 2009. This period saw interest rates rise from a low base to sharply higher levels and is, therefore, ideal to study the impact of rising rates on the debt servicing ratio. This period is also the most recent historical experience for Indian borrowers from which they can draw some guidance for the future.

We consider the following numerical examples where we chart out the debt-service burden for the borrower under three different scenarios:

a. where the prime lending or the main advance rate of banks adjusts upward in a gradual manner - this is a hypothetical case.

b. where the rate increase is as depicted above - sharp and significant - as happened in the housing loan market in the 5 years between 2004 and 2009. This is, therefore, a real world example.

c. Where the prime lending rate or the main advance rate adjusts downward in a gradual manner - this is partly a hypothetical case since we have had some experience with falling interest rates in the period from 2001 up to early 2004. Its significance, though, was not that high since housing related lending began to pick up robustly only by 2nd half 2003 and early 2004 (see Chart 1 above), by which time the low point in the interest rates cycle was being reached.
(The illustration of the debt service ratio for the fixed rate product has only theoretical significance since pure fixed rate lending is almost absent in the Indian housing loan market. The illustration will nevertheless help for comparison purposes).

It is interesting, therefore, to note that large volumes of housing loans (relative to the earlier period) was beginning to get done as the interest rates cycle was about to turn. That a large amount of floating rate lending has taken place since then only highlights the narrow choices borrowers have faced and thereby spotlights the larger issues we are addressing in this study.

Teaser' demands structural solutions

As the numerical examples clearly show, teaser and floating rate loans do pack a lot of damage potential for the individual borrower in the form of high debt servicing costs and distress. The concerns expressed by the RBI, therefore, are clearly justified. The broader questions though are: what drives banks to teaser loans and what can be done on the financial education front? It is clear that structural solutions are required in this environment.

We have assumed the following movements in the PLR and the resultant floating interest rate changes on the loan. For the sake of simplicity, it is also assumed that interest rate changes occur at the end or commencement of every year. The debt repayments are worked out on that basis.

That completely fixed long term loans generate their own set of risks is clear from the pattern on debt servicing noticed from Chart 3. In this scenario where market rates have declined gradually after the loan has been taken out, it can be seen that the floating rate loan emerges a winner by a considerable margin. The DSR for the floating rate loan is a clear 5 per cent points lower than the fixed rate right through the 10 year period.

Households which have taken out fixed rate loans would obviously feel that they have missed out on the much cheaper floating rate loan. It is a significant opportunity loss. The availability of re-financing, though, could mitigate the extent of this opportunity loss.
But it is important to remember that the DSR on the fixed rate loan does not rise. It is just that it falls more slowly than the DSR on the floating rate loan. In that sense the fixed rate loan has turned out relatively more expensive.

If people are encouraged to view everything in terms of relative cost they will feel they have had a bad deal with the fixed-rate mortgage.

But it is not relative cost that really causes hardship. It is the increases in the cost of debt relative to households' ability to pay that causes the real stress. In such a scenario, people may have to cut back on other spending, may fall into arrears and ultimately may even face repossession of their property. Households would be more likely to run into problems if they had variable-rate mortgages and interest rates rose sharply like in Scenario B than if they had fixed-rate mortgages and interest rates fell sharply.