Variable Interest Rate

Sub-chapters: Introduction Legal situation How do three elements improve the position of the client? Initial period of fixation Disclosure of information Conclusion

Introduction

A variable rate loan is a loan where the interest rate is not fixed through the life of the loan contract but can vary during the life of the contract. Variable rate loans were for a time quite popular in BiH as the interest rates at the start of the loan contract were generally lower than the interest rates were for a fixed rate loan contract of the same length. In the period 2007-2010, many bank customers with variable rate loans were surprised when banks increased the interest rates on these loans quite frequently and sharply. The banks were within their legal rights under the contracts the customers had signed as these contracts placed no limitations on the frequency with which banks changed the interest rates on these loans and did not require the banks to specify the basis they were using to justify the interest rate increases. But many banks made significant mistakes in their public communications of their actions.

One way to resolve these problems was to have adequate regulations about the basis on which a bank could change the interest rate on a variable rate loan and the frequency with which they could do so. This was applied in amendments to the RS Banking Law in 2010 to improve disclosure and protection for the users of bank and micro-finance services. The Federation of BiH has introduced similar amendments but they wait to be passed.

Legal situation

Client should pay attention on several important elements relating to variable rate loans. (that are regulated with the amendments to the RS Banking Law in 2011):

i) The loan contract has to specify the basis on which the loan rate could be changed in the future: The two main characteristics on basis for interest rate change (in RS Law) are that:

- the basis has to be a variable element that is 'officially released.' (eg.a reference rate or the consumers' price index). The consumer price index is really just another option for the reference rate to be put in the loan contract for a variable rate loan with the agreement of the bank and the borrower.

- the basis cannot be something that can be influenced by the ‘unilateral will of either of the contracting parties.' While this clause refers to both of the contracting parties, a bank customer has little scope to influence a reference rate so the clause is primarily aimed at reducing the influence of the banks on the interest rate changes on variable rate loans.

ii) The loan contract has to specify the minimum frequency with which the bank can change the interest rate in the future.

iii) Any changes to the nominal interest rate and the impact that this has on the effective interest rate (EIR) of the loan have to be advised to the customer BEFORE the new nominal and effective interest rates take effect.

How do three elements improve the positon of the client?

A) Reference rates: A reference rate serves as a benchmark for the banks and microcredit organizations by which they can adjust the prices for the financial services and products they offer. Interest rates on variable rate loans will go up and down in line with the trends in the reference rate specified in the contract. Banks cannot choose whether to pass movements in the reference rate onto the customer. The specification in the loan contract will require them to do so. This applies equally to periods when the reference rate is trending down. For some of the reference rates being used in loan contracts, such as EURIBOR, this has been happening over the last year or so (see graph below). Bank customers should therefore have seen the interest rate on many of their variable rate loans going down when Euribor declines, but also in the other direction. If this hasn't been happening, they should ask their bank why this has not happened in the case of their loan contract. If they get no reply or an unsatisfactory reply from their bank, they should raise the issue with the Banking Ombudsman in their Entity.

The reference rate has to be something that is officially calculated and transparent so that it is easily accessible to both the customer and the bank.

The most commonly used basis or reference rate in BiH are the Euribor benchmark rates. Some variable rate loans can use LIBOR and e official consumers' price index

Euribor is a measure of the interest rate on interbank lending in the Eurozone. There are several Euribor benchmark rates calculated and published so a BiH borrower needs to be sure that the loan contract specifies clearly which Euribor rate is being used. The loan contract should not leave the bank free to switch between the various Euribor benchmark rates on its own initiative.

The Euribor benchmark rates are sponsored by the European Banking Federation. Euribor benchmark rates were first published in 1998. The rates are calculated and published daily and can be readily and easily found on the internet and in financial newspapers. One of the main influences on the Euribor interest rates is the base financing interest rates of the European Central Bank (ECB) For exmaple, in July 2012, the ECB reduced this rate from 1% to 0.75%. In May, 2013 it reduced it further to 0.5%. As a consequence, Euribor interest rates decreased a little in 2012. Interest rates on variable rate loans in BiH that use Euribor as the reference rate in the loan contract should also have reduced a little in 2012.

However, borrowers in BiH who have a variable rate loan that uses Euribor as the reference rate should be aware that the reference rate can rise at times and the interest rate on their loan will rise with it. Future changes in the ECB's base rate will depend on economic conditions in the Eurozone (if economic activity and inflation start to increase, the ECB will begin to raise its base lending rate).So BiH borrowers whose variable interest rate is tied to Euribor rates should not get the shock of a sudden large increases in the interest rate on their loan. But increases are likely to in the future because Euribor interest rates are currently (in 2013) unusually low.

Graph: Euribor and ECB rates (2008-2013)

Libor benchmark rates are similar to Euribor except that the Libor rates come from the London inter-bank market. They are used as a benchmark in financial products in many other countries. Because the KM exchange rate is tied to the Euro and most of BiH's main trading partners are Euro-zone countries or countries whose own currencies are linked to the Euro, it is more sensible to use Euribor than Libor.

Consumers Price Index measures changes in the price level of a basket of goods and services purchased by an average household. The CPI is prepared and published monthly by official statistical institutions in BiH

Graph: Consumer Price Index, annual growth rate (inflation), 2008 -2013

B) Frequency of interest rate changes: A customer entering into a contract for a variable rate loan needs to understand that a bank does not need to get written approval from customer for changes to the interest rate on a variable rate loan. The change is based on changes in the reference interest rate that the bank and customer have agreed to use in the contract.

The most common time limit is quarterly. This means the bank can change the interest rate no more frequently than once a quarter, though they should not change the interest rate if the reference rate specified in the contract has not changed. The bank cannot change the variable interest rate within deadlines different from the agreed deadlines

C) Impact on effective interest rate of the loan (EIR): for a variable rate loan, the EIR given to the customer at the time of the negotiation of the loan assumes that the interest rate on the loan WON'T change during the life of the loan. But for variable rate loans, the bank does have the contractual right to change this rate during the life of the loan. The important point for customers to be aware of in regard to the EIRs on variable rate loans is that this EIR will change every time the bank varies the nominal interest rate on the loan. However, the bank has to include in the contract the basis they will use to change the rate, the frequency with which they can change the rate and every time they change the nominal interest rate, they are required to calculate a new EIR and tell the customer the new EIR in advance. So the changes in EIRs have some limitations on both the size of each change and their frequency

Initial period of fixation

Banks offer sometimes loans with initial period of fixation of the interest rate. The initial period of fixation is a predetermined period of time at the start of a contract during which the value of the interest rate cannot change. The value of the interest rate is only considered to be unchangeable if it is defined as:

Such loans have the nature of a fixed rate loan for a period at the beginning of the loan, typically one or two years, when the interest rate is fixed and cannot be changed by the bank. After expiration of the initial period, loan contract will give the bank the right to change interest rate on the loan, so the loan will convert to a variable rate loan at that time. The interest rate becomes changeable in accordance with the agreed procedure for calculating the variable interest rate (reference rate, spread, frequency of interest rate changes).

Borrowers should paid attention to these details and how the banks advertise their loan offers. The banks sometimes advertise loans with the fixed interest rate, but do not provide details if it is only for certain period (initial period of fixation) or whole duration. Banks have been known to advertise loans as a fixed rate loan even when there is a clause in the loan contract specifying that the interest rate is only fixed for a certain period and can be changed by the bank after that period. Second, if the loan is a loan procedures with an initial period of fixation and a subsequent variable period, the bank needs to specify at the beginning the procedures that they will use to vary the interest rates once the variable period begins and the customer should agree to these as part of the initial loan contract. Third, some banks (more so in some other countries than in BiH) sometimes induce customers to sign one of these loans by setting a low interest rate during the initial fixed rate period. Customers would borrow up to the limit they could service at this low initial interest rate and were then unable to service the loan when the variable rate period started and the interest rate rose significantly.

Disclosure of information

The regulations needs to impose requirement on banks to publically disclose data on the trends of the value of the agreed reference rates and make them available to customers in an accessible location in its business premises. If the reference rates used in variable rate loans are Euribor, Libor and the Consumer Price Index, information on the levels and trends of these rates should be displayed in all bank branches. Other institutions should also put data on the reference rates being used in variable rate loan contracts in BiH on their web-site as an alternative source of information for consumers.

When a bank proposes to change the interest rate on a variable rate loan because of a change in the reference rate specified in the loan contract, the bank must advise the customer on the change of such a rate in writing or in another agreed manner PRIOR to the beginning of the application of the changed interest rate and state the date on which the changed interest rate will start to apply. The bank also has to deliver free of charge to the customer a changed loan repayment schedule that reflects the new interest rate.

Conclusion

The interest rate on a variable rate loan can change over time. Without adequate regulation, this represented a risk for the borrower as the banks could decide for themselves, the reasons they would use to change the rates and the frequency with which they did so. The appropriate regulation (like amendments in RS Banking Law) and sufficient knowledge on the side of borrowers reduce these risks by requiring the bank to agree with the customer the basis on which future interest rate changes will be made and the frequency with which they can be made. They also require the bank to disclose changes in the interest rate to the borrower in advance of their taking effect.