How Decrease In Repo Rate Affects Interest Rate?

From interest rates to tenure and monthly EMIs, people consider several factors when taking out a home loan. Nonetheless, most people don’t think much about the repo rate. In other words, the interest rates your bank offers on home loans depend on the lending rate at which funds are provided to the bank by the Reserve Bank of India (RBI).

Still confused?

Well, the concept of repo rate is still a puzzle to most borrowers. However, it doesn’t have to be so. Here’s a complete guide on the repo rate and how it can influence interest rates on home loans.

When you urgently need funds, you approach banks or other financial institutions for a loan. But what do such financial institutions do when they face a crisis like inflation?

Well, they approach the country’s central bank, in our case, the Reserve Bank of India (RBI). And just like you, financial institutions borrow funds from the RBI at a fixed interest rate, known as the repo rate.

So in simple words, the repo rate is the interest rate at which RBI lends funds to financial institutions when they face a shortage of funds.

“Repo” stands for “repurchasing option”. When financial institutions need funds from the RBI, they use their government securities (bonds and treasury bills, aka T-bills)  as collateral. They sell these securities to the RBI and sign an agreement to buy them back later at a predetermined price.

Now that you know what the repo rate is, let us look at its importance.

RBI Repo Rate: Why is it Important?

The repo rate plays an integral role in the country’s monetary control. Primarily, it helps authorities deal with inflation.

During inflation, the repo rate is hiked by the RBI. This means that financial institutions have to pay a higher interest rate on funds they borrow from the RBI. This makes lending expensive for such organizations. So, they use two methods to mitigate their loss and help tame inflation. 

First, financial institutions pay interest rates on deposit accounts. This encourages customers to keep their money in banks for higher returns. As a result, the flow of money in the economy (liquidity) decreases, and growth is restricted.

Second, financial institutions increase the interest rates on various loan options. This prevents people from taking out loans. So, consumers take fewer loans and make fewer purchases. Again, this reduces the money at their disposal and results in a fall in liquidity and demand in the economy.

Both these ways contribute to bringing down inflation. Now, what happens when the country is inching toward deflation?

During a period of deflation, RBI lowers the repo rate. This makes interest rates cheaper and the return on deposits minimal. Therefore, businesses feel more encouraged to avail of loans and withdraw funds for investment. As a result, the supply of money in the market increases, and the economic growth rates improve.

The Repo Rate and its Effect on Interest Rates

As per the update from RBI on 30th September 2022, the current repo rate is 5.90%. The repo rate was increased by 50 basis points from 4.40% in May 2022. The apparent change in interest rates and deposit rates was to be implemented soon. This resulted in much distress for people planning to get a loan.

The hike would make loans costlier, whether they are housing loans, car loans, or personal loans. Hence, borrowers will be subject to a hefty interest rate and huge monthly EMIs. This affects both people who are planning to get a loan and those who are in the process of repaying a loan with a floating interest rate.

All housing loans issued since October 2019 are subject to the repo rate. So, every time there is a hike in the repo rate, the home loan rate will be revised.  Typically, the change in the repo rate leads to a tenure adjustment. Meaning people who are planning to get a home loan will have to deal with longer loan durations and in turn, more EMIs, and more money repaid in the form of interest.

Nonetheless, people who have taken a loan with a fixed interest rate, such as personal and car loans, are safe. An increase or decrease in the repo rate wouldn’t affect their monthly instalments.

Final Thoughts

Financial experts believe that the RBI will continue to raise the repo rate. The rise in the repo rate in September was the third hike in 2022. It was earlier increased by 40 basis points and then 50 basis points in May and June, respectively.

The inflation in India is growing beyond RBI’s tolerance level. So, it is forecasted that the repo rate might be raised by 0.5% by the end of this year.

As a borrower, you must stay prepared to deal with the hike in repo rates. As a first step, apply as soon as possible if you plan to get a loan. The repo rates will only increase. So, the earlier you get a loan, the lower the interest rate you pay. Also, ensure you get a fixed-interest rate loan, such as a personal loan from Piramal Finance. This will keep you on the safer side as far as EMIs are concerned.

Next, if you are in the process of repaying a loss, ask your lender if the loan terms can be revised. If yes,  request your lender for an increase in EMI if your loan has less than 5 years of tenure remaining. Additionally, switch from a floating to a fixed interest rate loan.

Lastly, if your remaining tenure on an ongoing loan is more than 10 years, you might want to think of a  loan balance transfer. Research the various loan interest rates offered by multiple lenders. Find the most affordable one and switch to that option.