The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) announced a revised repo rate of 4.00% and a reverse repo rate of 3.35% effective from December 2020. Since March 2020, the repo rate has been reduced by 115 basis points.
How does the repo rate affect EMIs?
We often hear of the RBI either cutting down the repo rate or increasing it by certain basis rates. And it’s always good news for commercial banks when there’s a decrease in these rates. So, how does it affect your EMI and how is it beneficial to you?
Before we understand how it changes your EMI, let’s understand the workings of repo rate and EMIs.
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 installment is known as an Equated Monthly Installment (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.
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 funds from the central bank, they have to pay the central bank an interest amount subject to a predetermined lending rate. This is known as the repo rate.
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 has introduced the MCLR regime with hopes of changing the way commercial banks function. 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.
EMI Calculator Repo Rates FAQs>
- What kind of loans get affected by cut in repo rates?
- Do home loan interest rates reduce as soon as there is a cut in repo rates?
- How often will banks change interest rates on loans that are linked to the repo rate?
Repo rate cuts will impact loans such as home loans, vehicle loans, and personal loans.
The Reserve Bank of India (RBI) has issued guidelines to banks that state that any cut in repo rates have to be passed onto the consumers at the earliest.
The Reserve Bank of India's guidelines are that interest rates linked to an external benchmark rate have to be reset every three months.