In an advanced monetary policy review in May 2020, the RBI governor announced that the apex bank is reducing the repo rate further by 40 basis points. It was the last among the consecutive rate cuts until now, i.e. October 2020, bringing down the current repo rate to 4%. This change brought a fresh optimism among borrowers, especially those who are repaying long-term credits like home loans.
Advances like housing loans typically create a repayment commitment lasting for up to 15-20 years and need proper planning for efficient management. The repayment liability of a housing loan is made of two components, i.e., the principal and interest. However, a small change in interest rate can significantly affect the EMIs a borrower is paying due to an increased repayment liability.
In this regard, a change in the repo rate has a significant effect on the EMIs that homeowners are paying. Hence, it is vital to know about it and how it affects the home loan liability of individuals.
What is a repo rate?
A repo rate means the interest a financial institution needs to pay to the RBI on the borrowed funds and is an abbreviation for the term ‘repurchase rate’.
When individuals borrow funds from a lender, they are required to pay a specific interest on their borrowing. The same applies to financial institutions, as in, when they borrow funds from the RBI, they are liable to repay as per the current repo rate.
Apart from assisting financial institutions during their liquidity shortfall, repo rate is a vital tool of RBI’s monetary policy. The Reserve Bank of India controls the flow of money in the Indian economy and tames increasing inflationary trends with assistance from this rate and other key policy rates.
During high inflation, this rate goes up to discourage financial institutions from borrowing funds, which ultimately reflects in their rate of lending. This technique reduces ‘liquidity’, thus curbing high inflation rates. A reverse method is also used when inflation is low to prompt lenders and borrowers to avail credit.
Therefore, any change in this rate can affect one’s home loan EMIs, and currently, it is a boon for home buyers as the RBI has slashed its repo rate subsequently, bringing the current repo rate down to 4%.
Repo rate and home loan EMIs: How are the two tied?
The connection between repo rate and home loan EMIs is direct, as any change in this rate also affects the rate of lending, thus impacting a loan’s EMIs. The benefits of low repo rate that financial institutions receive, they pass it on to borrowers as a part of the interest rate charged.
As mentioned above, lenders borrow funds from the RBI, and they need to pay interest on it. In the current repo rate situation, this cost of availing funds from the RBI has lowered. Therefore, financial institutions can now offer better benefits to their borrowers. As a result of this new and reduced repo rate, interest rates available on home loans, and other credit options have also dropped. The opposite is also true, as such, when repo rate surges, the cost of borrowing for financial institutions also increases, thus reflecting in the rise of interest rate on various credit options.
A point to note here is that financial institutions do not implement these changes overnight. They take some time to adjust the lending rates as per their internal or external benchmarking system followed.
Here is an example to further simplify this concept. A borrower has availed a home loan of Rs.30 lakh at an interest rate of 8.75% for 15 years. It translates to an EMI of around Rs.29,983. In case of a repo rate cut, the home loan interest rate lowers to 8.5%. It will also reduce the EMI to about Rs.29,542. Initially, this may not seem like a significant amount, but given that the borrower needs to make EMI payments for a long term, he/she can save significantly on the total interest paid.
MCLR and RLLR – The benchmarking systems of lending
Before 2016, when the base rate system was in operation, borrowers did not always receive the benefits of this repo rate change. With the introduction of MCLR, the system brought in better transparency as it factored in the repo rate change into interest rate calculation. However, it is set to phase out with the introduction of the new, repo rate-receptive lending system known as RLLR or Repo Linked Lending Rate.
Existing borrowers should, however, know about MCLR based home loans and their impact on the total repayment liability. They can then request for a switch to the RLLR lending system against nominal fee payment to experience quick transmittance of key policy rate changes.
When availing of a new loan, renowned lenders also provide pre-approved offers to streamline the loan application process and help save time. These offers are applicable to financial products like home loans, loans against property, etc. Borrowers can quickly check their pre-approved offers by submitting their essential contact details.
The drop in the current repo rate brought good news to prospective homebuyers. They can thus assess what to expect from this announcement. It will help individuals to avail credit at a reduced interest rate and save a substantial amount on interest repayment.