How Do Fluctuations In Gold Prices Impact Your Gold Loan?
I. Introduction
- Brief explanation of what a gold loan is
Gold loan is a collateral based lending product. In gold loans, the borrower is able to avail a loan from the lender on a condition that the borrower gives custody of their gold to the lender as a pledge, this pledge serves as a counter-risk measure for the lender.
- Importance of gold prices in determining loan value
Loan value in case of gold loan depends upon the value of the gold collateral. And the value of the gold collateral is dependent upon the price of gold. Hence, the gold prices are highly important in determining the loan value that a borrower can get by pledging their gold collateral.
- Purpose of the article: To explain how changing gold prices affect gold loan terms and outcomes.
The purpose of the article is to discuss and understand how gold prices impact the gold loan, and what are the underlying reasons behind the fluctuation in the gold prices.
II. Understanding Gold Loans
- Definition and how gold loans work
Gold loan has been one of the most famous lending products in India for decades. It is a collateral based lending product where the borrower’s gold serves as a collateral to secure a loan. How gold loans work is that the borrower avails a loan from the lender and pays off the outstanding along with the applicable interest rate as per the loan agreement. However, to set-off the lending risk, the lender takes custody of the borrower’s gold, and gives back the custody once the loan is paid back in full with all applicable interest and charges.
- Role of gold as collateral
Gold in India has a high cultural significance, and if considered from the lens of a financial instrument, the metal has been able to produce fantastic returns over a long investment timeframe, and also the fact that the metal has a high demand in the secondary market, makes it highly liquid, and desirable as a component of an overall portfolio from diversification point of view. These qualities make gold an amazing collateral for the lenders as it can be readily liquidated in the secondary market by the lender to recover any outstanding dues in case of a default by the borrower.
- Loan-to-Value (LTV) ratio: What it means and why it matters
Loan to value (LTV) ratio is the amount of loan that a borrower can secure in relation to the value of their gold collateral. It is a highly relevant indicator to understand the value of a loan that one is able to secure as a loan. As per the guidelines by the Reserve Bank of India (RBI), the maximum LTV that can be offered by the lenders in India is 75%. I.e. for a gold collateral of a market value of INR 100,000 - a maximum of INR 75,000 can be availed in gold loan. While borrowing, it is important to choose a lender offering maximum LTV. Lenders like indiagold offer LTV up to 75% on gold loans!
III. What Drives Gold Price Fluctuations?
- Global economic conditions (inflation, interest rates, currency strength).
Gold is a globally traded commodity. Hence, its prices are also dependent upon global economic conditions and indicators. Various economic indicators such as inflation, interest rates, and currency strength have a direct or indirect impact on the demand and supply forces for gold which eventually has a major impact on the gold prices. While studying gold price trends, it is important to also take these factors into consideration as it helps understand the underlying drivers and their impact on the prices.
- Demand and supply dynamics
Like any other commodity, gold’s price too is driven by the demand and supply forces in the market. Higher demand in relation to the available supply contributes to the increase in the prices, and vice versa. Demand and supply dynamics in the market is one of the biggest reasons behind changing gold prices in the international markets.
- Geopolitical tensions and market sentiment
Gold is often considered as a hedge for uncertainty. Reason being, gold is generally considered safe due to its solid demand and ability to generate consistent returns over long investment horizons. In events of geopolitical tensions, when the investors look to divest from their risky high growth investments to invest in a safer alternative, the demand for gold increases, and so does the price. The same applies for market sentiments during uncertainty. The demand for safe investments is one of the major forces behind the fluctuation in gold prices.
- Central bank policies
Central bank policies aim at controlling the economic factors within the country, these policies can be expansionary or contractionary in nature, which can impact the demand for gold locally, essentially impacting the price levels.
IV. Impact of Gold Price Increase on Gold Loans
- Higher valuation of pledged gold
This is one of the biggest effects of gold price on loan amount. An increase in the gold price essentially inflates the value of the collateral held by the lender. Example - Let’s suppose you have availed a gold loan amounting to INR 75,000 against a gold of value of INR 100,000 but now the gold price has increased by 15%, the value of the underlying gold collateral will have also increased by 15% to INR 115,000
- Possibility of higher loan amounts
Since the loan amount is decided based on the value of the gold collateral, an increase in the value of the gold also opens up the possibility to avail more loan. Let’s consider the above example. Earlier, the borrower has availed an INR 75,000 loan against gold of value INR100,000, and now that the prices have increased by 15%, the gold value has increased to INR 115,000, thus this opens the possibility for the borrower to avail additional loan to bring up the loan value by 15% to INR 86,250 from the earlier INR 75,000
- Increased LTV ratio benefits (if policies permit)
The Loan-to-value ratio and gold price changes have an impact on the maximum gold loan that a borrower can avail. Depending upon the lender's policies, an increase in the gold price may result in an enhanced loan eligibility. I.e. if you have availed the maximum loan as per the LTV policy of the lender, and then the increase in the gold price results in an overall increase in the value of the gold collateral, you may qualify for availing more loan as you’d not have availed the high available loan as per the LTV policy.
- Lower risk of margin calls or top-ups
Lower risk of margin calls is one of the biggest effects of rising gold prices on loan repayments. An increase in the gold price boosts the overall value of the gold. This essentially qualifies the borrower for an enhanced loan amount, and if the borrower chooses to not go ahead with the enhanced gold loan amount, it decreases the risk of margin calls or to-ups!
V. Gold loan Impact Due To Decrease in Gold Prices
- Reduced value of gold collateral
A drop in the gold prices can result in a subsequent drop in the value of the gold collateral. Continuing on our earlier example, let's suppose in this case the gold price in the market drops by 5% then the value of your gold collateral will go down from INR 100,000 to INR 95,000 which will subsequently have an impact on the amount of loan that you can borrow from the lender.
- Risk of margin call or loan recall
Upon the gold price drop and loan value decrease, the value of the underlying collateral also decreases, and the maximum loan that can be availed against the said collateral also decreases by the same margin. So if you’re someone who has availed the maximum available gold loan against a gold collateral, if the gold prices decrease, then you may get a margin call from the lender to repay the difference amount to maintain the same loan to value ratio (LTV) as permissible.
- Requirement to repay part of the loan or pledge more gold
If the gold prices take a hit, the value of gold collateral decreases, and so does the maximum loan amount that can be availed against the said gold collateral. As discussed earlier, if so happens that you’ve availed the maximum available gold loan as per the LTV policies of the lender, and the gold prices take a hit, then you may receive a margin call to pay the difference to keep the LTV as per the loan policy, or to pledge more gold.
- Potential risk of gold auction if loan isn’t serviced
If the gold value decreases substantially, it may result in the total liability shooting up considerably in relation to the total market value of the gold. In case of non-repayment in such a case, the lender may put your gold collateral up for auction to recover outstanding. Hence it is imperative to always check gold loan eligibility in fluctuating gold markets to keep a check on the possible margin calls you may receive on your existing gold loans.
VI. Lender Perspective: How Institutions React to Price Changes
- Revaluation of pledged gold
Institutions continuously reevaluate the value of the underlying gold collateral as and when the gold price changes. This helps them have a track on the risk exposure, and various lending ratios as set forth by the regulators.
- Policy changes in gold loan LTV ratio or gold loan interest rates
Institutions are quick to react to changes in policies such as a revision in the LTV ratio of change in the gold loan interest rates. Thai allows them to stay compliant with the regulations, be competitive with their competitors, and offer best possible services to the customers. Lenders like indiagold are often considered as the first ones to react to the policy changes and implement the same towards increasing the customer satisfaction.
- More stringent risk assessments during volatile periods
During price volatility, the lenders usually do a more stringent assessment, as due to the underlying price movement, the risk exposure may change significantly in a matter of days!
VII. Borrower Strategies in Response to Price Fluctuations
Fluctuating gold prices and loans goes hand in hand, and there are various strategies which may help the borrowers with their gold loans in times of price fluctuation!
- Monitoring gold prices actively
Monitoring gold prices actively helps in understanding the causes of sharp changes in prices, and also helps understand how and when to take advantage of a sudden price movement. By doing so, a person planning to borrow against their gold can wait for the right price or pull the trigger at the right price and get maximum money as a loan for their gold.
- Timely loan repayment or top-ups to avoid auction
Gold prices are driven by a host of factors as we discussed earlier in the article. To avoid surpassing the maximum LTV triggered by a price fluctuation and essentially managing a buffer, timely repayment can really help. Also, it would be prudent if the borrower makes regular payment towards their due principal to ensure that they don’t receive a margin call due to a bigg change in the price levels.
- Choosing fixed vs. floating rate gold loans
Fixed interest rates, as the name suggests, fixes the interest rates at the start of the loan, whereas, with floating interest rates, the applicable rates change as and when there is a change in the bank rate or applicable lending rate by the central bank. It is prudent to take a calculated approach and choose the option which most aligns with effectively low cost paid in the form of interest payments.
- Opting for short-term loans in volatile markets
Generally, short term loans attract lower interest rates. Hence, if there is a relief in terms of lower interest rates available for short term loans, and the requirement too is for a short term, then it is prudent to opt for a short-term loan to save on some interest related costs.
VIII. Regulatory Guidelines and Protections
- RBI’s guidelines on LTV ratio
The Reserve bank of India (RBO\I) has put forth the regulations regarding the Loan to value (LTV) ratio. As per this regulation, the lenders can give a maximum of 75% as gold loan in relation to the value of the gold. These guidelines aim to ensure that the lenders have the room to accommodate their risk exposure for frequent price changes of gold. Among the sea of lenders, indiagold shines among the very few lenders that offer highest LTV to its borrowers.
- Auction and recovery procedures
The lenders are supposed to follow set guidelines before proceeding with auctioning of the gold to recover the dues. The borrower is to be given sufficient communications, and notices. And the auction details like date, day, and collateral detail to be published in advance.
