The Reserve Bank of India (RBI) had increased the repo rate by 25 basis points according to the second bi-monthly monetary policy statement for 2018-19 released on 6 June 2018. The repo rate was increased from 6% to 6.25%. This was the first time the repo rate has increased in more than four years. In addition to the increase in the repo rate, the reverse repo rate was also increased from 5.75% to 6%. The Marginal Standing Facility(MSF) Rate and the Bank Rate both stood at 6.50%, increasing from the previous rate which was at 6.25%.
However, the Reserve Bank of India increased the repo rate, the reverse repo rate and the Marginal Standing Facility Rate as well as the Bank Rate again on August 1, 2018. The Repo Rate increased from 6.25% to 6.50%. The reverse repo rate increased from 6% to 6.25%, and the Marginal Standing Facility Rate and the Bank Rate rose from 6.50% to 6.75%.
How is Repo Rate related to EMI?
We often hear about the RBI hiking or slashing the repo rate. When the RBI slashes rates, its good news for commercial banks. However, you must be wondering whether it is beneficial to you or not. Read further to learn how the repo rate affects your EMI.
What is Repo Rate?
To understand how the repo rate affects your loan EMI, we must first know what repo rate means. Commercial banks borrow money from the Reserve Bank of India when they have a shortfall of funds. The repo rate is the interest rate the RBI charges the commercial banks for lending these funds. The monetary authorities of the country can use the repo rate to control inflation.
When there is inflation, the central bank can increase the repo rate. This will discourage the commercial banks from borrowing from the central bank. This will reduce the supply of money in the economy and the inflation will come down. On the other hand, if there is a fall in inflation below desired levels then the central bank can lower the repo rate. This acts as an incentive for commercial banks to borrow more money. They, in turn, will lend more to their customers which will lead to an increase in the supply of money in the country.
What is EMI?
When you take a loan from a bank, you are required to pay it back in monthly installments. Each installment is known as an Equated Monthly Installment or EMI. Every EMI comprises of two components - the principal and the interest. Banks, usually, try to collect most of the interest as soon as possible. Therefore, when you are repaying a loan, your EMI will have more of the interest component than the principal repayment amount at the beginning of the loan tenure. This gradually changes and your EMI will comprise of a high principal repayment amount and less interest repayment sum towards the end of the loan tenure.
Commercial banks and Repo Rate
Commercial banks function by sourcing funds through various avenues, lending the funds, and making the profit on the interest. Banks raise funds through the following channels:
- Savings Account Deposits
- Current Account Deposits
- Fixed Deposits
- Recurring Deposits
- Bonds and Debentures
- Borrowing From Other Banks and Institutions
- Borrowing From the Central Bank
When banks borrow from the central bank, they will have to pay the central bank an interest amount subject to a predetermined lending rate which is known as the repo rate. When the repo rate is low, commercial banks may find borrowing from the central bank to be a good option.
The relationship between Repo Rate and EMI
Ideally, a low repo rate should translate into low-cost loans for the general masses. When the RBI slashes its repo rate, it expects the banks to lower their interest rates charged on loans. However, most of the time, this is not the case. Under the base rate system, banks had a base rate below which it could not lend money. Banks would charge the base rate plus an additional interest rate, also known as a spread, as they saw fit. Under an ideal situation, when the RBI slashes its repo rates, the cost of funds becomes lower for banks. Therefore, they can offer loans at lower rates to customers. This means that the borrower will have to pay a lower EMI amount as the interest payable will be lesser. On the other hand, when the RBI increases its repo rate, it becomes more expensive for banks to acquire funds, forcing them to increase their rates of lending. So, for the end customer, the loan would be more expensive as the interest rates are higher. Therefore, a high repo rate means that the customer has to pay a higher EMI.
The reality of Repo Rate and EMI
In reality, the ideal relationship between the repo rate and the EMI does not play out. It has been observed that when the Reserve Bank of India slashes its rates, banks are slow to reduce their rates of lending. It, usually, takes a long time for banks to incorporate the changes. However, when the RBI increases its repo rate, banks are prompt to increase their rates simultaneously. Owing to this behavior of banks, the RBI has, now, introduced the MCLR regime in hopes of changing the way commercial banks function with regard to interest rates. Banks are now required to publish new interest rates every month for at least 5 tenures. Furthermore, there are tighter regulations on the spread that they can apply to their base rate. Banks can have a margin of 25 basis points above the MCLR. Under the new MCLR regime, the repo rate and the EMI might have a stronger relationship than in the past.