How Changes in Interest Rates Affect Borrower Repayment Capacity

Vinu: Manu, whenever the RBI changes interest rates, bankers immediately start discussing its impact on borrowers. Why is it such a big concern?

Manu: Because a change in interest rates directly affects the borrower's loan repayment obligation. Even a small increase in the lending rate can significantly increase the interest burden, especially for borrowers with large outstanding loans.

Vinu: Does this affect every borrower in the same way?

Manu: No. Borrowers with floating-rate loans are impacted immediately or after the next rate reset. Those with fixed-rate loans generally remain unaffected until refinancing or renewal.

Vinu: Can you explain with a simple example?

Manu: Suppose a company has a term loan of ₹2,00,00,000.

At 9%, annual interest is ₹18,00,000.

If the rate increases to 10.5%, annual interest becomes ₹21,00,000.

That's an additional ₹3,00,000 every year without borrowing a single extra rupee.

Vinu: How does this impact credit appraisal?

Manu: Higher interest means higher debt servicing. If business profits remain unchanged, repayment capacity weakens. Ratios like DSCR, Interest Coverage Ratio (ICR) and overall cash flows may deteriorate.

Vinu: Which borrowers are more vulnerable to rising interest rates?

Manu:

Typically:

Businesses with thin profit margins.
Highly leveraged companies.
Borrowers with large floating-rate loans.
Businesses facing volatile cash flows.

These borrowers may struggle to absorb higher finance costs.

Vinu: What should a credit officer analyse when rates increase?

Manu: A banker should assess:

Additional annual interest outgo.
Ability of operating cash flows to absorb the increase.
Revised DSCR and ICR.
Whether repayment schedules remain comfortable.
The borrower's contingency plans.

Vinu: Can rising interest rates affect working capital limits too?

Manu: Absolutely. Higher interest on Cash Credit (CC) or Overdraft (OD) limits increases finance costs. If sales and profitability don't improve proportionately, working capital stress may emerge.

Vinu: Can borrowers reduce the impact of higher interest rates?

Manu: Yes. They may:

Improve operational efficiency.
Reduce unnecessary borrowings.
Prepay expensive loans where feasible.
Strengthen cash flow management.
Negotiate better borrowing terms if eligible.

Vinu: What's the key takeaway for bankers?

Manu: Interest rate changes don't just affect EMIs—they influence a borrower's overall repayment capacity. A prudent credit officer should always evaluate how changes in finance costs impact cash flows, debt servicing ability, and the long-term sustainability of the loan.

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