How does repo rate impact loan interest?

10:57 PM RAWAT 0 Comments

Repo rate is a financial instrument that the Reserve Bank of India implements to regulate the flow of money and credit in the Indian economy. Repo rates are subject to frequent alterations by the RBI in an attempt to align the lending policies of financial institutions with the Government of India’s (GOI) objective of controlling credit supply, consumption, liquidity, and growth.

HFCs extend the impact of changes in the repo rate to individuals availing credit such as home loans, personal loans, business loans, among other borrowing options. As an extension, loan interest rates undergo variations periodically as per the prevailing repo rates.

Why does RBI regulate repo rate?

Repo rate or repurchase rate refers to the interest rate that RBI charges on financial institutions when they borrow funds from the RBI. Lenders borrow a percentage of their monetary operations from the RBI based on this rate.

It is also vital to consider the reverse repo rate, which is the rate of interest applicable on deposits made by financiers or lenders to the RBI.

The RBI therefore changes repo rate periodically which affects the lending rate at which financiers lend a credit to an individual. The RBI also uses repo rate as an instrument to control the availability of credit to individuals as per their demand, consumption, and spending parameters.

How does repo rate influence interest rates on loans?

Repo rate decided by the RBI has extensive impacts on the interest rates charged by a lender on different categories of loans. It is calculated by basis points (bps), where 100 bps equals 1% of repo rate. For instance, the current repo rate is 5.15%, down from 5.40% by 25 bps. Individuals should plan their loan requirements as per RBI rate cuts and what to expect from such announcements.

Fluctuations in repo rate have direct implications on the interest rates charged by lenders on individuals availing home loans, business loans, and personal loans. The impacts on rates of interest on the basis of repo rate are as follows –

       Increase in repo rate

Lenders have to pay higher interests on the funds borrowed from the RBI when the repo rate is increased. This causes a reduction of available funds present with the financial institutions.

With the reduction in the lenders’ loanable funds, the cost of availing credit increases. This implies that loans are available to individuals at a higher rate of interest and higher EMI payment.

RBI increases repo rate to primarily curb inflation and flow of credit by reducing the volume of loanable funds. This measure aims to discourage individuals from availing loans from financial institutions owing to a significant increase in cost of loans.

       Decrease in repo rate

RBI curtails repo rate to increase credit availability in an economy. As lenders are liable to pay lower rates of interest on the funds borrowed from RBI, they can retain a substantial corpus of loanable amount. A higher supply of loanable funds suggests that financial institutions charge affordable rates of interest and lower EMIs on individuals availing credit.

The objective behind a reduction in repo rate is to enhance money supply within an economy by making loans affordable. Individuals can thus access higher amounts at attractive interest rates to finance their requirements.

New external benchmark for financial institutions

Financial institutions accumulate a major percentage of loanable funds from long term deposits from their customers. The remaining fund volume is borrowed from RBI, which is a limited portion of loanable funds. Financial institutions are thus often slow to transmit the impacts of repo rate alterations to their customers.

To combat this, the RBI introduced the following new external benchmark for all loans including home loan in effect from 1st April, 2019 to provide customers benefits on floating interest rates and more holistic revisions to the rates –

       Repo rate determined by the RBI.
       GOI’s Treasury bill yield for 3 months.
       GOI’s 6 months’ Treasury bill yield.
       Other benchmarks as applicable.

HFCs that select repo rate as a benchmark offer Repo Linked Lending Rate (RLLR) to their customers to incorporate the direct influences of repo rate fluctuations and adding transparency in the MCLR calculation process. Individuals should check repo rates to have an idea about how the RBI’s rate hike is likely to affect their loans.

The RBI thus regulates repo rate to control credit availability. This instrument has direct impacts on lending rates of the credit availed by individuals. Loan applicants should check the tax saving and other advantages offered by home loans.