Repo Rates: How It Affects The Interest Rate?

The Reserve Bank of India, or RBI, uses the repo rate as a tool to maintain liquidity in the market and manage cash flow. The Monetary Policy Committee (MPC) makes bimonthly changes to the repo rate, depending on economic conditions. These changes are made to combat inflation, induce cash flow, and increase investment. 

During the pandemic, the RBI slashed the repo rates, to help get the economy back on track. There has been a recent hike in August, and the monthly EMI for the general public is set to rise. Several banks have already increased their borrowing rates, while others are set to do so with the recent hike in repo rates by the RBI. 

What is the repo rate?

Financial institutions pay the RBI a certain interest when they borrow money. They do so by selling securities such as treasury bills. This is like how people who want to borrow money from commercial financial institutions or banks have to pay a certain interest rate or put up collateral.

Commercial banks also need funds for lending purposes. Besides taking deposits from the general public, they can also borrow from central banks. For commercial banks, the collateral is treasury bills sold to the RBI, and the interest rate is known as the repo rate.

The repo rate not only helps central banks with credit availability but is also an effective tool for the RBI to tackle inflation. If inflation is high, the RBI increases the repo rate to discourage banks from borrowing credit, which, in turn, reduces liquidity in the economy. The repo rate is also reduced when inflation is low, to encourage banks to borrow more credit. This leads to a market supply hike, triggering fresh investment activity. 

What is the reverse repo rate? 

Commercial Banks also charge interest from the RBI to lend credit to the banking regulator. The reverse repo rate is used to control inflation levels by the RBI to absorb liquidity from the system. It is done by increasing interest rates to encourage commercial banks to lend money to the RBI, further depleting the excess liquidity from the system. In this way, banks are not left with a lot of money at hand.

Bank rate vs. repo rate 

Commercial and central banks use repo rates to determine borrowing and lending activities. The repo rate and bank rate are the lending rates at which central banks lend funds to commercial banks. While both rates are used as tools to control the cash flow, there is a significant difference between them, and one should not be mistaken for the other. 

While the repo rate is charged for repurchasing securities sold by the commercial banks to the central banks, the bank rate is charged by the central bank to commercial banks against loans. Collateral, such as securities, bonds, and agreements, is only involved in charging repo rates and not bank rates. The repo rate is relatively lower than bank rates. The bank rate caters to the long-term financial requirements of commercial banks, unlike the repo rate, which focuses on short-term financial needs. 

How does the repo rate affect interest rates?

The repo rate paid by the bank to central banks and the interest rates paid by borrowers to commercial banks are directly proportional.

Since the banks pass on the increasing cost of repo rates to the borrowers to cover the gap in expenses, the interest rates on multiple loans will also increase. In simpler words, an increase in repo rate means an increase in interest rates. 

How does a change in repo rates impact home loan EMI?

When the RBI increases its lending rate, home loan interest rates also go up. Even a small rate hike will impact borrowers as it makes home loans expensive. Home loans, vehicle loans, education loans, personal loans, business loans, credit cards, and mortgages, all affected by the rise in repo rates. Moreover, when borrowing cost is increased, people are discouraged from spending unnecessarily on goods and services, thereby reducing market demand. This also disrupts the supply and demand chain across industries. 

Other impacts of repo rates

The RBI’s short-term hike on commercial banks has unintentionally harmed the country’s economic growth.  hikes in repo rates are necessary to combat inflation, economic growth is slowed by a fall in demand. When goods and services become more expensive, people are less likely to buy them. 

One positive effect of repo rates is that consumers with savings and fixed deposits may find a hike in repo rates beneficial. 

Money supply and investment in the market will also be slowed when borrowing money becomes more expensive. The real estate sector is more affected than any sector by repo rates. 

You can make a balance inquiry to understand the EMI hike for your borrowings.

How does the repo rate affect the Indian economy? While India is on the path to overcoming the economic setback caused by the COVID-19 pandemic, the Indian government predicts that it will take at least 12 years to revive the economy. Low-interest rates are doubtful and unexpected, only to be announced after 12 years. 

Current repo rates 

On 30th September 2022, the Monetary Policy Committee raised the repo rate by 50 basis points. This increased the current repo rate to 5.90% and is the fourth hike in five months. Commercial banks that pushed interest rates to 6.6% will now push them to 8.5%. Borrowers without room to extend their loan tenure will observe a hike in EMI by15%. However, new borrowers need not expect an increase in rates, as banks can revise their spreads and charge lower rates in the future. 

The bottom line is you must know how repo rates affect interest rates charged by banks. This is particularly important if you are considering getting a home loan. Visit Piramal Finance to understand more about home loans and get financial assistance from professionals.