When you hear the news about the Reserve Bank of India (RBI) changing the repo rate or reverse repo rate, you might wonder—what does it mean for me? How does this impact my home loan, my savings, or even the price of things I buy every day?
Understanding these key interest rates can help you make smarter financial decisions. In this blog, we will break down the concepts in simple terms and explain how a repo rate cut can benefit banks and borrowers, especially those with home loans.
What Is the Repo Rate?
The repo rate (short for repurchase rate) is the interest rate at which commercial banks borrow money from the Reserve Bank of India (RBI) to meet their short-term financial needs. In simpler terms, it’s like a loan that banks take from the RBI when they are running low on cash.
A Simple Example to Understand Repo Rate
Imagine you are running a grocery store. One day, you realize that you don’t have enough cash to buy supplies, but you know that once you sell your stock, you will have the money. So, you borrow money from a friend and promise to return it with some extra interest.
In this case, you are the commercial bank, your friend is the RBI, and the interest you pay is the repo rate. When the repo rate is high, borrowing from the RBI becomes expensive for banks. When the repo rate is low, borrowing is cheaper, making loans more affordable for people and businesses.
What Is the Reverse Repo Rate?
The reverse repo rate is the opposite of the repo rate. It is the interest rate at which RBI borrows money from commercial banks.
A Simple Example to Understand Reverse Repo Rate
Let’s go back to our grocery store example. Imagine you made a lot of money and have extra cash sitting idle. You decide to lend this money to a trusted friend who promises to return it with interest after a short period.
Here, you are the commercial bank, your friend is the RBI, and the interest you earn is the reverse repo rate. When the reverse repo rate is high, banks prefer to keep their money with the RBI rather than lending it to businesses or individuals, which reduces the circulation of money in the economy.
Why Does RBI Change the Repo Rate?
RBI adjusts the repo rate based on economic conditions.
If inflation is high, RBI increases the repo rate to make borrowing expensive. This reduces spending and controls inflation.
If economic growth is slow, RBI lowers the repo rate to encourage borrowing and spending, which boosts economic activity.
To stabilize the currency, RBI may adjust the repo rate to control fluctuations in the value of the Indian Rupee.
To manage liquidity, RBI changes the repo rate to ensure there is neither excess liquidity (which can cause inflation) nor a liquidity crunch (which can slow down growth).
To influence credit availability, a lower repo rate encourages banks to lend more, stimulating business investments, while a higher repo rate tightens credit availability, reducing excessive borrowing.
To align with global interest rate trends, RBI may adjust the repo rate in response to changes in monetary policies of major economies like the US Federal Reserve or the European Central Bank.
How a Repo Rate Cut Helps Banks and Borrowers
When RBI cuts the repo rate, it has a ripple effect on the economy. Here’s how:
- Banks Get Cheaper Loans from RBI
When the repo rate is cut, banks can borrow money from RBI at a lower cost. This increases liquidity in the banking system, meaning banks have more money to lend.
- Lower Interest Rates on Home Loans
Since banks are borrowing at lower rates, they pass on the benefit to customers by reducing the interest rates on loans, including home loans.
For example, if you have a home loan of ₹50 lakh at an interest rate of 8% for 20 years, your EMI would be around ₹41,822. If the RBI reduces the repo rate and banks lower the interest rate to 7.5%, your EMI would drop to ₹40,280, saving you ₹1,542 per month and ₹3.70 lakh over the loan tenure!
Alternatively, if you choose to keep the EMI constant at ₹41,822 instead of reducing it, the lower interest rate will reduce the tenure of the loan. Instead of taking 240 months (20 years) to repay the loan, you might be able to clear it in approximately 224 months (18 years and 8 months), saving almost 16 EMIs, which amounts to nearly ₹6.69 lakh in total savings.
- Easier Access to Loans
With lower interest rates, loans become cheaper and more people can afford to take them. This increases demand for housing, automobiles, and businesses, leading to overall economic growth.
- Boost to the Real Estate Sector
Lower home loan interest rates encourage people to buy homes. This benefits builders, contractors, and real estate developers, leading to job creation in the construction sector.
- Lower Cost for Businesses
Companies that take loans for expansion, machinery, or working capital also benefit from lower interest rates, which helps them grow and create more jobs.
Impact on Savings and Fixed Deposits
While a repo rate cut is great for borrowers, it is not so good for savers. When banks reduce loan interest rates, they also lower the interest rates on fixed deposits (FDs) and savings accounts.
New Deposits May Earn Lower Returns: If you plan to open a new fixed deposit after a repo rate cut, you may get a lower interest rate compared to older deposits.
Existing FDs Remain Unchanged: If you have already invested in an FD before the rate cut, the interest rate will remain the same until maturity, so existing depositors are not affected immediately.
Reduced Passive Income: Individuals who rely on interest earnings from savings accounts and FDs might see their income decrease, affecting their financial plans.
Shift to Other Investments: With lower FD returns, investors might look for alternatives such as mutual funds, stocks, or gold, which carry higher risk but offer better returns.
Impact on Retirees: Retirees who depend on fixed deposits for monthly interest earnings may need to reconsider their investment strategy to maintain their standard of living.
Conclusion
The repo rate and reverse repo rate play a crucial role in shaping India’s economy. A repo rate cut is good news for borrowers, especially home loan customers, as it lowers their EMIs. However, it also means lower returns for depositors. If you already have a home loan, it’s important to check with your bank whether they have passed on the rate cut to you and if you can benefit from lower interest rates.