How Repo Rate Increase Affects Your Finances?

The Reserve Bank of India (RBI) acts as a statutory body that is directly or indirectly in charge of banking regulation, money supply, inflation management, issuance of currency, maintaining overall financial stability in India and numerous other functions. RBI acts as a regulator and supervisor of India’s financial system. It always has to walk the tightrope between growth and inflation, overheating and slowdown, excess liquidity and drying up of funds. Naturally, the RBI uses several tools to manage its functions. 

No Magic Wand - RBI’s Tools To Manage Monetary Policy

Given the crucial nature of its functions, the RBI has several tools to carry out its functions. These are:

• Repo rate – The rate at which banks and NBFCs borrow from RBI (against collateral). RBI may increase repo rate or reduce it, as demanded by the prevailing situation
• Reverse repo rate – The rate at which RBI borrows from banks and NBFCs
• Open market operations – RBI’s direct buying and selling of short-term securities in the open market to regulate the supply of money in the market
• Bank rate – Rate at which RBI lends to banks and NBFCs (without collateral)
• Reserve ratios – Ratio of total deposits that banks need to park with RBI (Cash Reserve Ratio) and Ratio of total deposits that banks need to keep with themselves (Statutory Reserve Ratio).

For the scope of this article, we shall focus on the repo rate and its effect on your finances. But before that, let us first understand the repo rate a little more in detail.

What Is The Repo Rate?

The repo rate is short for Repurchase Option Rate. It is the rate at which RBI lends to banks in India. This lending is done against collateral such as Government bonds, Treasury Bills, etc. In times of fund shortage or urgent funding requirements, banks approach the RBI and borrow money for a specific tenure. They pay interest to the RBI for using these funds, at a rate which is called the repo rate. The RBI can increase repo rate or decrease it, thereby controlling the overall interest rates prevailing in the economy and also the overall supply of funds in the system.

How Repo Rate Affects Your Finances?

As mentioned earlier, the repo rate is the rate at which banks and financial institutions borrow from the RBI.

Repo Rate Increase Effects

If inflation is running high, the RBI may increase repo rate, thereby making borrowing costlier for banks and NBFCs. This higher cost of borrowing is subsequently passed on to customers (borrowers) through rate increases. A rise in repo rate increases the rate of interest on all types of loans such as Personal Loans, Business Loans, Car Loans, Home Loans, etc.

Since loans become more expensive, the demand for loans, on the whole, goes down. Hence, people (and businesses) tend to conserve cash, thereby bringing down the overall level of activity in the economy. This results in a reduction in inflation. Thus, the repo rate increase impact is that the level of inflation goes down. For the borrower, if RBI hikes repo rate, loans become more expensive.

Effects Of Reducing The Repo Rate

If the RBI wants to boost the overall activity in the economy, it can reduce the repo rate. This reduces the cost of borrowing for banks and NBFCs, who in turn, pass it on to their customers. Thus, the interest rates on all types of loans go down. This leads to a higher demand for loans, thereby boosting the level of activity in the economy.

Thus, the repo rate is a key instrument for controlling inflation or boosting demand. Similarly, loans, it directly affects the interest rate on loans.

How Repo Rates Have Evolved Over Time?

The following has been the repo rate trend over the past five years

Date	Repo Rate (%)
4-May-18	6.00%
6-Jun-18	6.25%
1-Aug-18	6.50%
7-Feb-19	6.25%
4-Apr-19	6.00%
6-Jun-19	5.75%
7-Aug-19	5.40%
4-Oct-19	5.15%
27-Mar-20	4.40%
22-May-20	4.00%
4-May-22	4.40%
8-Jun-22	4.90%
5-Aug-22	5.40%
30-Sep-22	5.90%
7-Dec-22	6.25%
8-Feb-23	6.50%

Source: Investing.com

As seen in the above table/chart, the RBI resorted to reducing the repo rate as an immediate reaction to the COVID-19 pandemic. Economic activity came to a near-standstill owing to multiple lockdowns, hence it was necessary to reduce the repo rate to boost economic activity. Once the economic activity was nearly back on track, RBI raised repo rates once again to prevent the overheating of the economy. This is an example of how the RBI uses the repo rate to tame inflation and boost growth.

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Conclusion

To conclude, the interest rate on your loan is directly proportional to the repo rates prevailing in the economy. Hence, it is an effective tool available to the RBI for furthering its objectives related to the monetary system. An economy that has a high rate of inflation sees a rising trend in repo rate while an economy that is low on growth sees a declining trend in repo rates. The only solace in a rising repo rate scenario is the subsequent rise in deposit rates!

Frequently Asked Questions

How much EMI will increase after the repo rate?

It is difficult to predict the precise quantum of an increase in loan interest rates after an increase in repo rates. However, banks and NBFCs generally pass on the rate hike/decline to customers to stay competitive and profitable. The quantum of pass-through might not be exact for all banks and NBFCs, but the trajectory is the same. E.g., if the RBI increases the repo rate by 50 basis points (1% = 100 basis points), all lenders will increase their loan interest rates by a similar quantum. However, it is extremely unlikely that a lender will take the opposite direction, i.e., decrease the loan interest rate after an increase in repo rate by the RBI.

What happens when the repo rate is increased?

When the repo rate is increased, the cost of borrowing increases for banks and NBFCs. Hence, to protect their margins, they increase the loan interest rate for their customers. Thus, a rise in repo rate leads to a rise in loan interest rates.

What is the current repo rate in India? 

As of March 2023, the prevailing repo rate is 6.50%