Teaser Loans: Much Ado About Nothing Or A Debacle In The Making?
To be or not be Over the last year or so, teaser home loans have been launched and
re-launched with enough fanfare by a few banks to attract customers with lower interest rates that are fixed in the initial 2-3 years of the home loan. At the end of this period, the applicable floating rate of interest as linked to the base rate of the bank will kick in and be charged from the borrower.
Why the noise?
Well, the criticism and apprehensions related to these products stems from two aspects:
1. Customer related
* The fact that these loans are offered at lower fixed interest rates in the initial 2-3 years and then linked back to the prevailing interest rates for the subsequent period of the loan is seen by some as a potential issue for customer who might be in for a shock with the increase in their EMI.
* Critics also feel that the aggressive competition in the home loans space might be resulting in banks not being transparent enough with customers about the potential increase in rates (if interest rates move upwards) at the end of the initial teaser period. This could result in customers getting into the long term borrowing arrangement without being adequately informed of potential increases in their loan servicing costs.
2. Banking system related
* The loans were introduced at a time when liquidity was flush and interest rates fairly low, thereby making the cost of borrowing for banks to be at levels where offering lower fixed interest rates to customers for the first 2-3 years made financial sense for the bank. With interest rates rising over the last 6-9 months, the cost of funds for banks has already gone up and many feel that the low fixed lending rates (in the vicinity of 8%) are just not sustainable for banks and can add undue pressure on their profitability.
* There is also a fear of increased defaults on such loans once again putting pressure on the banking system similar to the one witnessed as part of the subprime crisis in the US. This fear stems from the sharp increase in realty prices over the last few years which together with availability of low rates could lure individuals to go for such loans in the hope that realty prices will continue their move upwards. If however, interest rates were to go up sharply or realty prices were to come down drastically, there could be higher number of defaults on such loans.
Is the noise justified?
Let us once again look at this one from both the aspects discussed above:
1. Customer related
* The only reason or situation where the customer will actually be taken by surprise on these products would be if he is not aware or made informed of the change at the end of the initial low rate period. Most customers, in todays age of easily available information, are quite unlikely to be blind to this fundamental feature of the product. Having said that, transparency enforced by regulations could reduce this risk even further. Mandatory documentation such as a Most Important Document that needs to carry all key conditions of the product and must be signed by the customer before the loan is approved and/or disbursed is one answer. The document could go on to detail potential scenarios such as what would the EMI look like if the rates were to move say between -3% to + 3%. At the end of the day, it is all about transparency. After all, even with non-teaser loans, how many of us have faced situations where we are never sure why our EMI increase when rates go up but never seem to come down when the rates are on their way down. One also needs to keep in mind that even in a non-teaser but floating rate products, a rise in interest rates can lead to higher EMIs.
* Other than making sure that the customer is well informed, one needs to leave the actual decision making to what one can assume to be an adult individual with a reasonable level of financial sense. The product might just make complete sense to someone who has a few outstanding liabilities in the first couple of years and can actually sustain a higher EMI (if they do come about) subsequently. On the other hand, if an individual wants to take on a liability purely betting on an increase in realty prices then he is one who wants to take that risk the key here would be the eligibility criteria to be used by banks (covered in the next section).
2. Banking system related
* The risk of higher defaults can be addressed by once again regulating the way banks define and implementing their eligibility criteria. The criteria currently in place already, reportedly, takes into account the interest rates that might be applicable post the initial period and not the lower fixed rates in the first few years. As long as this is firmly in place and can be monitored and reviewed, it will not be any different from the customers that are taken to be eligible for non-teaser loans. In any case, the systemic risk for banks is lower in India due to the lower than 80% loan to value ratio.
* The issue with respect to the banks being able to sustain the products in light of the rising cost of funds should once again be a choice left to the banks subject to, perhaps, a few conditions or warning thresholds that will be monitored by the regulator. After all a dent in profitability is not something that most banks (especially the listed ones) would want to follow as a strategy. At the same time, RBI has already introduced a higher provisioning requirement for banks for teaser loans but the banks have now gone back to RBI for them to provide an explicit definition of what would or would not be considered teaser loans.
The answer is not an easy one but then issues related to financial products and financial/banking companies rarely are. In the end it is all about good regulation enforcing transparency both for the customer as well as the regulator. Over regulation should not kill what could be positives in a product/product category; at the same time under regulation could result in disasters just waiting to happen. Our central bank seems to have been able to walk the balancing line thus far when the banking systems elsewhere in the global economy were suffering. Heres hoping that it can continue to find the right balance.
by: isave
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