Banks due to liquidity crunch are under pressure to protect their margins and are required to review the pricing and structure of loans. Earlier loans which had a fixed rate of interest were considered to be insulated from interest rate vagaries.
Banks are under pressure to protect their margins and need to review the pricing and structure of loans. Previously, loans carrying a fixed rate of interest were considered to be insulated from interest rate vagaries. Therefore they are supposed to remain neutral to the changes in the market rates of interest. Hence increase in the interest rates, have entailed a loss of banks.
Banks have introduced the reset clause in their fixed home loan documents to result in change in the interest rate at a future date. A reset clause permits banks to review rates at the end of certain number of years. In the housing loan agreements the reset clause is either explicitly or implicitly. The clauses come into effect at the time of increase in the interest rates. Effectively, this makes the fixed rate loans equivalent to floating rate ones.
The reset clause also enables banks to revise their interest rates on the loans in case of certain circumstances. Under this clause the banks have the discretion to increase the interest rates in case the market rates increase. This gives the banks a escape against interest rate increases at a future point in time. But it is a disadvantage for the borrower.
The interest rate on fixed is higher than the floating rate because there is an additional element of risk, which the bank has to bear in the future. Generally, people opt for fixed rate loans when the interest rates are low therefore they prefer to lock-in the interest rates for the long term. Originally, banks were offering these loans without any apprehensions of any radical increases in interest rates in the future. But, as the interest rates started going up, banks are introducing the reset clause.
However the interest rate reviews and hikes can be linked to various factors - the prime lending rate (PLR) of the bank, money market conditions and so on. Furthermore, the increases might apply to select borrowers - loans above a certain amount or loans for certain tenure. The tenor of review and increase in the interest rates may be mentioned - once in a quarter or once in six months.
Recently the interests rates have gone up subsequently therefore banks are increasingly introducing the reset clauses to increase the interest rates on the fixed rate loans as well.