Effect of increased RBI interest rates on your loan

New repo rates of 4 percent and a reverse repo rate of 3.35 percent, effective December 2020, were announced by India's Reserve Bank monetary policy committee. Since March 2020, the repo rate has fallen by 115 basis points. The repo rate is routinely lowered or raised by a certain amount of basis points. For commercial banks, a decrease in these rates is always welcome. Now that you know how it affects your EMI, how can you use it to your advantage?

To understand how repo rates and EMIs operate, we first need to understand how repo rates function.

How much is the repo rate?

The Reserve Bank of India helps commercial banks in India when they run low on cash. The repo rate is the interest rate levied by the Reserve Bank of India to commercial banks when they lend money. This rate is used by monetary authorities to keep inflation in check.

Inflation may prompt the central bank to hike the repo rate. Commercial banks are deterred from borrowing funds, which reduces the quantity of money in circulation and reduces inflation. If inflation lowers, the central bank has the option of lowering the repo rate. Commercial banks use this as an incentive to provide loans. They will then transfer these funds to their customers, increasing the money supply.

To begin, what precisely is EMI?

To return a bank loan, you must do it in monthly instalments. Each payment is referred to as an Equated Monthly Instalment (EMI). Every EMI consists of the principal and interest. Banks typically collect the bulk of your interest over the first half of your term. The reason for this is because when you initially take out a loan, you'll have to pay a lot of interest on it. Your EMI will begin to contain a larger portion of principle as the duration of your loan draws to a close.

What is the relationship between EMIs and the Repo Rate?

Theoretically, a low repo rate should translate into lower borrowing costs for the general population. Banks are expected to drop their lending interest rates when the repo rate is lowered, as the RBI wants them to do. As a result, customers will pay reduced interest rates on their loans, cutting their EMI payments.

Likewise, if the repo rate rises, so does the cost of borrowing for customers. Due to the fact that commercial banks must buy money from the central bank at a higher price, they are forced to boost their lending rates.

It's not always this way, however. It takes time for banks to cut their lending rates when the Reserve Bank of India lowers its interest rates. When the repo rate rises, banks are keen to boost their lending rates.

Consequently, in order to change how commercial banks function, RBI adopted MCLR regime. Banks are now required to communicate new interest rates five times a month at the absolute least to customers. They also face greater restrictions on the spread they can apply to their base rate. An additional 25 basis points can be used by banks over the MCLR. Under the new MCLR structure, the repo rate and the EMI may be more closely linked than they were before.