In order to control and manage the inflation in the economy and promote the economic growth Reserve Bank of India (RBI) uses certain tools such as Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repo Rate, Reverse Repo Rate etc.
Repo Rate, Reverse Repo Rate are used by the monetary authorities to control inflation. Both repo rate and reverse repo rate is a monetary policy instrument which are used to control the money supply in the economy. Increases or decreases in the repo and reverse repo rate have an effect on the interest rate on banking products such as loans, mortgages and savings.
What is Repo Rate and Reverse Repo Rate?
Repo rate is the rate at which the RBI lends money to commercial banks in the event of any shortfall of funds. Repo rate is short form of Repurchase Rate.
Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.
In case of inflation in the economy, central banks increases the repo rate, other things remaining constant, and this act as a disincentive for the banks to borrow money from the RBI. This in turn, reduces the money supply in the economy and thus helps in arresting inflation.
However, with a fall of inflation in the economy the RBI takes a contrary position i.e. it decreases the repo rate, this in turn increases the money supply in the economy.
Considering, the fall in inflation in the economy the RBI has very recently announced a 25 basis point reduction in its lending rates.
Currently the RBI has cut the repo rate - its key lending rate - to 7.75 percent from 8.0 percent, where it had been for the past year. As a result, the reverse repo rate, the rate at which the central bank drains excess liquidity from the banking system, also moved down by 25 basis points to 6.75 percent.
How does a reduction in rate by RBI affect the Home Loans?
A cut in the key lending rate by the RBI indicates that now it will be cheaper for banks to take loan from the RBI. The same benefit is then passed on by banks to their customers by decreasing the rate of interest on their Home Loans.
However, the benefit of cut in rate by RBI not necessarily be immediately passed on to the customers. Though, these rate cuts will not have any impact on fixed rate home loans orfixed rate consumer loans, as the rate of interest is fixed with respect to fixed loans.
In case of existing customers of the bank, who have taken home loans on floating rate of interest will get the benefit of this rate cut. With a decrease in the rate of interest banks will either reduce the customer’s loan tenure or will reduce the EMI i.e. Equated Monthly Installment.
Generally, it has been noted that banks often reduce the tenure of the loan by keeping the EMI installment amount same. The rate cut will make a substantial difference if the remaining loan term/tenure is very long.
Home Loan EMIs has two components i.e. the interest and principal. The interest component is higher in the initial years than the principal; therefore a small change in the interest rate will have a huge impact. However, as the loan period progresses, the principal component increases and the impact of switching to a lower rate of interest has minimal impact.
In case a person has no other financial goals in future, it is better to opt for lower EMI and let the tenure of the loan remains same. The differential savings can then be allotted or invested in other important financial goals.
Lastly, with a cut in the lending rates the deposit rates of will also come down, therefore, one choose their investment options prudently.
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