Another thing about floating interest rates that I have not been able to understand is why they exist? (except for the fact that it benefits the banks.)
Let us take example for my home loan. When we took our mortgage at the time of buying the house, the rate offered to us was 8%. We agreed to the same and the money was transferred to the builder and we got our house. Now today the rate of interest is 10.5 % and the logic given to us is that since this is a floating rate of interest the market rate has increased and as our rate of interest is floating and marked to the benchmark rate of the bank we have to pay a higher rate of interest.
What I am unable to understand is that when I took the home loan we got it for 8% per annum, which means that the bank must have borrowed the funds (Cost of borrowing for bank) at less than 8%, for the bank to make any money on this loan. Let us say that the bank borrowed this money from depositors like you and me at an annual rate of interest of 6 % giving the bank a nice spread of 2%. Any expense that the bank does to originate the loan and later service the loan (salaries, advertisement, technology, call center etc) is subtracted from this spread and what is left is the profit for the bank. This basically means that the bank would have given this home loan to me at 8% with a clear assumption that it will be a profitable deal for the bank at 8%. Now when the bank is charging me at 10.5% per annum it means that the bank is making way more than what was originally projected so they are making more in profits now.
Now the logic for charging higher rate now that is given is that now the cost of funds has increased for the bank, so higher rate of interest. But my question is very simple the money that the bank gave to me was raised by bank at 6% and it was disbursed at that time so whey is it charging me at a higher rate of interest for money that was raised long ago?
On the contrary the new customers are often given a better deal in form of a lower rate of interest and teaser rate of interest. This basically means that I am subsidizing the low rate of interest for the new customers for the bank and I am not even getting any commission on the same.
If you have an answer to the same please inform me.
Next post we will examine what the Banks are doing withe rate of interest rate for FDs.