Repo rate is the rate at which commercial banks borrow money from RBI by using government bonds as collateral to achieve its fiscal goals.
The term 'REPO' refers to repurchase option or agreement. It is a monetary tool used by the RBI to allow commercial banks to borrow money, when in need, against collaterals such as government bonds and treasury bills. While lending money to commercial banks, the apex bank of India charges a certain amount of interest, which is called repo rate. This present repo rate is subject to change as per the RBI changing policies. In the situation of shortage of funds, commercial lenders can reach out to RBI to secure funds for a specified tenure by depositing government bonds as collateral. These financial institutions pay interest to the RBI as per the current repo rate. At the end of tenure, they can repurchase these bonds from the RBI by repaying a predetermined price. Repo rate is an important tool used by the central bank to control the rising inflation and maintain liquidity in the market. Therefore, depending upon the situation in the economy, a decision on the repo rate is taken. Monetary Policy Council, headed by the RBI Governor, takes decisions regarding the current repo rate.
RBI uses the repo rate as a control mechanism to increase or decrease liquidity in the economy. It helps in achieving stability. Any change in repo rate impacts the cost of credit for commercial banks. This eventually impacts the retail lending policies of commercial banks by bringing change in home loan interest rate, rates on bank deposit etc.
One has to pay an amount of interest on the principal money borrowed from the financial institution. This is commonly known as the cost of credit. Similarly, in a situation of cash crunch, banks and financial institutions borrow money from the Reserve Bank of India against the eligible securities they provide to the apex bank. The rate of interest on which RBI lend this money to the commercial banks and financial institutions is called repo rate. Repo stands for ‘repurchasing option’ or ‘repurchase agreement’ and it is an agreement between banks and RBI in which the latter lends loan to financial entities against security.
According to the policies, the RBI repo rate is instrumental in controlling and regulating the liquidity in the country’s economy. RBI uses this monetary tool to control the inflation, for example- by increasing the repo rate, the central bank limits the flow of cash in the economy and henceforth puts a restriction on increasing inflation and also brings it down.
On the other hand, if RBI brings any reduction in the rates, it eventually reduces the cost of credit resulting in more borrowings for commercial lenders. The recent cuts in RBI repo rates in the latest monetary policy has been devised to increase liquidity in the financial system, thereby driving the economic growth.
RBI keeps changing the repo rate to control the liquidity and with such modification in the repo rates, all sectors of the economy get impacted. The current repo rate stands at 4%, which is the lowest since January 2014. The effect of repo rate on home loan is quite significant. This low repo rate brings relief to homebuyers who are looking to borrow home loans at RLLR (Repo Rate linked lending rate) as the cost of credit will be reduced as interest outgo will be less. However, your final home loan rate will be RBI repo rate plus margin charged by your lender. Further, the effective loan rates depend on other factors such as loan amount, loan-to-value of the loan and the risk of the borrower.
To improve the liquidity in the market and control receding inflation, RBI reduces the repo rate. This reduction in the repo rate impacts the economy by increasing the cash flow and making funds available for the general public.
With repo rate cut, the financial institution can borrow money from RBI at a lower rate of interest and therefore, even the retail borrowers also get benefited from their respective lenders as the interest rate reduces. One of the most significant impacts of the repo rate cut is that consumers can avail finances at a lower cost of credit that eventually allows them to borrow a higher amount of loan and spend more increasing the cash flow in the system driving the economy towards growth.
RBI increases the repo rate to contain rising inflation. As the RBI repo rate increases, the loan becomes expensive for the commercial banks as the cost of credit increases. This RBI repo rate increase results in limiting the borrowing by these commercial banks, which eventually leads them to increase in the rate of interest for the retail borrowers.
One of the major impacts of the repo rate hike is the increased cost of bank loan for customers that limits them from borrowing money. This further results in a reduction in the cash flow in the market. This decrease in the cash flow helps in containing the rising inflation. Therefore, the apex bank uses it as an effective tool to control the rising inflation in the economy.
The impact of any change in the repo rate majorly affects the real estate sector, as home loans’ rates are directly linked with the RBI repo rate. The interest rate on a home loan is not decided by the commercial banks or housing finance company independently but it is linked to the external benchmark. Therefore, any change in the repo rate affects the home loan interest rate
In 2019, RBI issued a circular for banks and lending institutions to offer home loans linked to the new external benchmark and majority of lenders chose the repo rate as the external benchmark following the model of Repo Rate Linked Lending Rate (RLLR). Therefore, changes in the repo rate affect the home loan borrowers as it directly impacts the interest outgo on their home loan. Home loan rates linked to repo rate are usually composed of repo rate plus base spread or margin. A spread or margin is a component of repo linked home loan that customers pay above the repo rate for a home loan, which is decided by their respective lender. There are two types of spread, namely base spread and additional spread, which are decided by the banks based on factors such as loan amount or risk of the borrower. As and when RBI changes its repo rate, the interest rate of repo rate linked home loan will also change by the same point basis. Therefore, whenever there is a change in the repo rate, there will be a change in your EMIs. However, your EMI will change as per the reset date decided while availing the loan. Though the maximum reset frequency by RBI for repo rate linked home loan is of 3 months. For example: If you have availed a home loan at 8% and after two months, the RBI reduces the repo rate by 40 points basis, your rate of interest will also reduce by the same point basis and will settle at 7.60%. However, your EMI will change after 1 month as the reset period is of three months.
As per the RBI latest guidelines, commercial banks introduced repo rate linked home loan, under which the rate of interest on floating home loan will be linked to the external benchmark such as repo rate decided by the Reserve Bank of India. Earlier these loans were linked to MCLR (Minimum Cost to Lending Rate). Repo rate is the rate at which the central bank lends money to the commercial banks against securities. RBI has also instructed the banks to allow the borrowers to transfer their home loans from MCLR to repo rate loan. Under repo rate linked home loan, the rate of interest on the floating home loan is subject to change as and when the repo rate changes. For example: if RBI’s repo rate is 4.35% and is cut down by 35 points and changed to 4%, since the repo rate linked home loan is linked to an external benchmark, therefore the RLLR (Repo Rate Linked Lending Rate)will also get reduced by 35 points. In the case of the repo rate hike, the rate of interest on home loan increases. However, the effective RLLR-linked home loans depend on various factors such as the amount of loan, the loan-to-value of the loan and even the risk factor of the borrower. There is also a spread or margin that is charged by the banks to cover their costs.
Repo rate is an effective tool used by the apex bank to control and monitor the inflation, liquidity and money supply in the market. The change in the repo rate also affects the cost of borrowings by banks. In the case of rising inflation, RBI increases the repo rate to control inflation. Once the repo rate increases, the cost of borrowing for businesses increases, lowering down the investment and cash flow in the market. On the other hand, in case of liquidity crunch in the economy, RBI reduces the repo rate following which the cost of borrowing reduces increasing the cash flow in the economy. It also helps in boosting economic growth and improves the cash availability for retail consumers.
Reverse repo rate is another tool used by RBI to control the rising inflation by absorbing the liquidity in the market. Reverse repo rate is an interest rate at which RBI borrows money from commercial banks. Reverse repo rate helps RBI get funds from commercial banks when in need by offering them an attractive rate of interest. In some cases, commercial banks park their surplus funds with RBI to earn interest on it. During high inflation, RBI increases the reverse repo rate so that commercial banks are encouraged to park their surplus funds with RBI to earn higher interest. In this way, the supply of money in the market will reduce, which can help in controlling inflation.
Repo and reverse repo rate are two important monetary tools used by the RBI to control the rising inflation and maintain liquidity in the economy. Repo rate is the rate at which RBI lends funds to commercial banks while reverse repo rate is the rate at which RBI borrows fund from commercial banks. Under repo rate, commercial banks borrow funds from RBI by using government bonds as collateral while under reverse repo rate deposit their excess funds with RBI to earn interest. Repo rate is higher than the reverse repo rate. Repo rate controls inflation and manages fund deficiency while the reverse repo rate reduces the overall supply of money in the economy. Higher the repo rate, cost of credit becomes expensive on the other hand increase in reverse repo rate encourages banks to park their surplus fund with RBI reducing the cash flow in the economy. Lowering of repo rate reduces the cost of credit for commercial banks allowing them to lend money to retail borrowers at a lower rate of interest while any reduction in reverse repo rate increases the cash flow in the economy as commercial banks reduce their deposit with the RBI.
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Last update on 11-Mar-2021
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