The standard computation method used to calculate the rate of interest on loans sanctioned after October 01, 2019, is as mentioned below:
The effective interest rate applicable on loans linked to the external benchmark is made of two components including the RBI’s repo rate and the spread.
Effective Interest Rate = repo rate + Spread
Repo rate is the rate of interest at which RBI lends money to commercial banks.
Spread is a combination of the following elements:
- Operating costs and Profit Margin: These include the operational and administrative expenses banks spend on servicing the loan.
- Credit Risk Premium: This refers to the borrower’s Risk profile and is subject to vary depending on his/her credit score.
As per Reserve Bank of India’s regulation, banks have the freedom to decide spread over and above the external benchmark. However, the credit risk premium can only be altered upon the considerable change in the borrower’s credit assessment. Moreover, the other components operating cost and profit margin can only be changed once in three years as the Spread resets periodically once in three years from the disbursement date.