Relationship Between Repo Rate and EMI

What is repo rate?

When there's a shortage of funds, commercial banks in India borrow money from the Reserve Bank of India. A repo rate is nothing but the interest rate the RBI charges commercials banks when they lend funds. This rate is also used by monetary authorities to control inflation.

In case of inflation, the central bank may increase the repo rate. This is to discourage commercial banks from borrowing funds, thus reducing the supply of money in the economy and bringing down the inflation rate.

Now, when there's a drop in inflation, the central bank may lower the repo rate. This acts like an incentive, encouraging commercial banks to borrow funds. They will then provide these funds to their customers, increasing the supply of money.

What is EMI?

When you take a loan from a bank, you are required to pay it back in monthly installments. Each installments is known as an Equated Monthly Instalment (EMI). Every EMI comprises of two components - the principal and the interest. Banks, usually, try to collect most of the interest in the first half of your tenure. That's why, when you're repaying a loan, your EMI in the beginning has a large interest component. This gradually changes with your EMI carrying a higher principal component towards the end of your loan tenure.

How repo rate impacts EMIs

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. This means, the loans offered to the customers have lesser interest rates, decreasing the EMI as well.

Similarly, when there's an increase in the repo rate, loans for the customer are much more expensive because of the hike in the interest rates. This is because commercial banks acquire funds from the central bank at higher prices, which forces them to bump up their lending rates.

However, this scenario doesn't always play out. It has been observed that when the Reserve Bank of India slashes its rates, banks take time to reduce their lending rates. However, when there's a hike in the repo rate, banks are quick to increase their lending rates.

That's why, the RBI introduced the MCLR regime with hopes of changing the way commercial banks function. However, currently only loans with floating rate of interest are linked with the MCLR. The MCLR was replaced by the external benchmark linked rate for fixed rate loans.