A few years ago, to increase transparency within the lending processes, the Reserve Bank of India made it mandatory for lenders to connect the interest rate on all loans to an external benchmark. This external benchmark in most cases these days is the Repo Rate. The Reserve Bank of India is responsible for changing the Repo Rate keeping in view inflation and economic growth in mind. In this article, we explore the meaning of the Repo Rate and the effect of an increase in Repo Rate on home loan EMIs.
The Meaning of Repo Rate Explained
Lenders may borrow funds from the RBI. In the normal scenario, the borrowing entity is not required to pledge any security. When banks borrow funds from the central bank of the country without pledging securities, RBI charges interest in the form of the Bank Rate. The current Bank Rate is 5.15%. However, sometimes lenders experience interbank liquidity issues and therefore, borrow funds from the RBI by pledging bonds and securities as collateral and enter into an agreement with the RBI that they will repurchase the pledged securities before a specified date. This agreement is called the Repurchase Agreement and therefore, the interest rate that the RBI charges in the case of such borrowings is known as the Repo Rate. The agreement clearly states that if the borrowing party fails to repurchase the pledged bonds and securities before the agreed date, the Reserve Bank of India can sell the pledged securities to recover the loan funds. The current Repo Rate for home loans is 6.50% per annum.
Also Read: Repo Rate Effect On Home Loan
Effect of Repo Rate Increase on Indian Economy and Home Loan Borrowers
The Reserve Bank of India increases the Repo Rate to control the flow of funds within the economy and push the growth of the economy back on track. When inflation peaks repeatedly, sending the prices of commodities beyond an affordable range, the apex bank of the country increases the Repo Rate, primarily to reduce the flow of funds within the Indian economy. The effect of this increase in the Repo Rate is that loans become expensive. When the rate of interest on loans goes up, borrowers borrow only to meet their most urgent needs. Borrowings, in general, go down. This also reduces the flow of funds within the Indian economy, thereby bringing inflation under control.
When the Repo Rate goes up, so do the home loan EMIs of borrowers repaying their loans on floating interest rates. In simpler words, when the Repo Rate goes up, home loans become expensive. More importantly, the interest payout on the home loan as well as the cost of borrowing the loan increases for individuals repaying their home loan on floating interest rates.
Effect of Repo Rate Reduction on the Economy and the Home Loan Interest Rates
The Reserve Bank of India reduces the Repo Rate when it wants to increase the flow of funds within the Indian economy and inject growth. When the Reserve Bank of India decreases the Repo Rate, lenders borrow funds from the central bank of the country at low interest rates and thus, are able to lend funds to clients at a lower interest rate. Thus, when the RBI decreases the Repo Rate, the flow of funds within the Indian economy increases. Since loan interest rates go down, people borrow more and have more to spend. This increases the flow of funds within the Indian economy, thereby bringing back on track the growth of the economy. More importantly, when the Repo Rate goes down, home loans become feasible. Individuals repaying a floating interest rate home loan find that their EMIs have gone down and they can save more each month. Further, a reduction in the Repo Rate also helps borrowers reduce the total interest payout on their loan and therefore, the total cost of borrowing the loan.
