04 March, 2019 Financial & Technical
The policy interest rate, which is the interest rate that the central bank of a country sets in order to control the fiscal market and the economy, is known by different names and has different rates in different countries.
The policy interest rate, which is the interest rate that the central bank of a country sets in order to control the fiscal market and the economy, is known by different names and has different rates in different countries. Be its overnight lending rate, discount rate, repurchase rate or, of course, our very own repo rate. Being the rate at which Reserve Bank of India (RBI) lends money to other banks, every time the RBI changes the repo rate it has a far-reaching effect on the entire financial sector, directly or indirectly.
In the last decade or so, this rate has touched a high of 8.5% and a low of 4.75%. Since September 2015, it has however stayed consistently between 6-7%. For each one of these increases and decreases, there is a well-documented cause and effect relation with a variety of factors. Take the recent example of last year’s repo rate hike, the first increase in the repo rate in the last four and a half years. It was RBI’s reaction to the high Consumer Price Index inflation, increase in global commodity prices, fuel prices and other global factors. The effect of it could be seen reduced money supply, lowering of demand and subsequently decrease in prices. There are various effects of the changes in the interest rate and the financial instruments and products are no exception.
Credit cards - Banks and financial institutions offering credit cards would also face the effects of any change in the repo rate. They would no longer be interested in borrowing from the RBI if the interest rate is raised as it makes borrowing from RBI a costly option. Credit card spends are a form of loan for the card user, therefore its rate of interest will reflect the banks desire to accumulate more funds from the users. However, credit card companies also use discretion, sometimes even on a customer to customer basis. It is almost an open secret that there other factors apart from the policy interest rate that decides credit card interest rate, like payment history, credit score, type of card, the amount owed etc.
Home Loans – For every increase in the interest rate by the RBI, the cost of funds of banks goes up. Given that they are now required to pay more for the amount that they borrow from the RBI, housing lenders take shelter in the Marginal Cost of funds based Lending Rate (MCLR). They often cushion the blow of the repo rate hike by increasing their MCLR. Although it makes the home loans expensive, it doesn’t happen overnight. If you are an existing borrower you will continue to repay at old rates till the next rate reset date. It is only after reset that the new rate becomes applicable. Now that the repo rate finally you’re your budget, you can compare and renegotiate your repayment with the lender. If the mutually agreed rate doesn’t yield you the desired savings, you can compare the rates of various lenders and switch lender if required.
A decrease in the repo rate should, ideally, similarly lead to a fall in housing interest rates as the lenders seek to expand customer base by offering competitive rates. The borrower should compare the MCLR changes and its reflection in the home loan interest rates across the various lenders.
Personal Loans - The effect of a change in interest rate on personal loans will depend on the type of interest charged against the loan, is it a floating interest rate or a fixed one? With a fixed rate of interest, the borrower doesn’t need to worry as any change in the repo rate will not affect the personal loan interest rate. Quite simply, the borrower doesn’t stand to gain or lose anything. It is only when the repayment of the loan is based on a floating interest rate that changes in RBI’s interest rate are reflected on the loan repayment structure. The general trend is that reduction in the repo rate increases the demands for all types of loan products. And it is the new borrowers and existing borrowers on floating interest rate who benefit whenever the bank responds to the fall in interest rate and decreases its interest rate as well.
Savings – People who are determined to save will save anyway, irrespective of the subtle changes that happen in savings interest rates. Nevertheless, when it comes to savings and deposits, an increase in the repo rate makes the availability of funds for the commercial banks scarce. So to increase funds, banks would rather raise the interest rates on savings to attract depositors. This direct relationship between the repo rate and the interest rates on deposits may become inconsequential under the influence of inflation, for example. Inflation can potentially make an increase in the interest of savings irrelevant because the interest on savings may not be able to compete with the rate of inflation. Therefore, in an inflationary economy like India, increased savings interest rate may mean higher return but, at the same time, reduced value of money and purchasing power.
Apart from these, the changes in the interest rates have a bigger macro-economic impact on the country and the world. The central bank can use it to address the economic slowdown fiscal deficit, business expansion and overall economic growth. And they often do so, after all, the repo rate is a very convenient tool to adjust the economy and tune it with the country’s financial policies and strategies.