How the interest rates are fixed by bank ?
The interest rate charged by banks comprises two components: Base rate and spread.
Base rate is the minimum rate of interest below which banks cannot lend. The system of base rates was introduced on July 1, 2010, replacing the previous Benchmark Prime Lending Rate (BPLR). Individual banks fix the base rate based on the broad guidelines issued by the RBI. Base rate calculations are largely transparent and are common for all borrowers. The only exceptions where banks may lend below the base rate are export credit and farm loans.
To arrive at the final lending rate, banks add some percentage points to the base rate. These additional percentage points are called the spread. For example, if the loan interest rate is 10.25% and the base rate is 10%, 0.25% is the spread. Banks calculate the spread based on their profit requirement, operating costs, risk and credit loss. Spread is decided at the time you avail of a loan and depends on factors, such as loan type, credit profile, etc. All borrowers benefit when banks announce a cut in base rate, but this is not the case when banks cut the spread.
Suppose your bank announces a rate cut of 0.25% in spread, while the existing interest rate is 10.50% and the base rate is 10%. The move will benefit new customers only as they will have to pay 10.25% while the existing ones will continue paying 10.50%.