What is repo rate and how does it impact your home loan EMIs?

The Reserve Bank of India on April 6, 2023, left the repo rate unchanged at 6.50% while announcing its first bi-monthly policy for fiscal 2023-24. on February 8, 2023, the apex bank increased the repo rate by 25 basis points. The increase brought the repo rate, at which the central bank lends money to scheduled banks in India, to 6.50%. That was the sixth consecutive hike in the repo rate this fiscal. Cumulatively, the RBI has hiked the repo rate by 250 basis points in FY23.

What does this decision mean for a home buyer?

Every time the RBI makes a change in the repo rate, home buyers are told that the cost of borrowing will become higher/lower, because of the change. As the repo rate has such a significant bearing on your financials, it is important to know everything about it and how it impacts your home loan liability. It is also essential to know how the reverse repo rate works, in order to have a better clarity on the working of your .

For instance, SBI customers who are currently paying a monthly EMIs of Rs 21,824 for a home loan of Rs 25 lakh for a 20-year tenure, will have to pay Rs 22,253 per month after the hike.  If the tenure of the same loan is 30 years, the EMI would increase to Rs 19,846 from 19,400 per month.

See also: All about RBI home loan interest rate

What is repo rate?

Just like borrowers have to pay a certain interest to avail of credit from banks, financial institutions also have to pay interest, for the money they borrow from the central bank. This interest is known as the repo rate. The term ‘repo’ is short for ‘repurchasing option’ or ‘repurchase agreement’. Under the arrangement, scheduled commercial banks provide securities such as treasury bills or gold to the RBI for availing of overnight credit in case of liquidity shortfall.

It is pertinent to mention here that banks need funds for lending purposes. Apart from taking deposits from the general public, they also have the option to borrow from the central banks. Repurchase agreements make this possible.

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Current repo and reverse repo rates

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Aside from helping banks with credit availability, the repo rate is an effective tool for the banking regulator, to control inflation. In case of high inflation, the RBI increases the repo rate, to discourage banks from borrowing. This eventually reduces the liquidity in the economy, subsequently taming the high inflation. A reverse technique is put in place, in case of falling inflation. In this scenario, the repo rate is reduced in a move to prompt banks to borrow more credit, which ultimately increases the supply in the market, triggering fresh investment activity.

Note here that the credit thus extended by the RBI to the banks, is provided only for overnight and the banks buy back their securities deposited with the banking regulator at a predetermined price.

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What is reverse repo rate?

Reverse repo rate is the interest which banks charge from the RBI, to lend credit to the banking regulator. Reverse repo rate is another tool used by the RBI, to maintain desired inflation levels, by way of absorbing liquidity from the system. By increasing interest, the RBI encourages banks to lend money to the RBI, which results in depletion of excess liquidity from the system. Banks, thus, are not left with a lot of credit to lend.

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Difference between repo rate and reverse repo rate

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Key facts about repo rate in India

• The repo rate is fixed and monitored by the RBI.
• Repo rate is a tool to control inflation.
• Banks adjust savings account and fixed deposit returns, based on the repo rate.
• Before October 2004, the repo rate was known as the reverse repo rate.

What is monetary policy review?

The RBI’s six-member Monetary Policy Committee, headed by the RBI governor, meets every two months, to decide its monetary policy and tweaks key interest rates, according to the prevailing economic condition. The monetary policy review also sums up the prevailing economic conditions of the country and elaborates on present and future actions that RBI plans to undertake, in order to support the economy.

How does change in repo rate impact home loans?

When the RBI lowers the repo rate, the cost of borrowing for banks goes down. Banks are expected to pass on this benefit to the consumers eventually. Conversely, home loan interest rates go up with the RBI making an upwards tweak in its lending rate.

Incidentally, banks are quicker in passing on the increase in rates to the customers, while they are generally quite slow in reducing their lending rates. So, even though changes in the repo rate should reflect in financial institutions’ interest rates immediately, only increases see fast transmission and often the RBI has to nudge banks, to pass on the benefits of reduced rates to borrowers.

With banks linking their home loan interest rates to the repo rate, since October 2019, faster transmission of policy could be expected in the future. Prior to that, banks used internal lending benchmarks like marginal cost of funds-based lending rate (MCLR), base rate and prime lending rate, to price home loans.

The MCLR, which came into effect in 2016, was an internal lending benchmark, allowing banks to ‘reset’ the loan rate, at an interval specified in the loan agreement. These rate cuts implemented by the banking regulator were not passed on to the customers by the banks as swiftly as they were expected to, while the burden was quickly passed on in case of an increase. “In case of MCLR-based loans, banks have to factor in their cost of deposit, operating cost, etc., apart from the repo rates, while calculating lending rates. Hence, MCLR-based loans are always likely to have slower transmission of policy rate changes,” says Naveen Kukreja, chief executive officer and co-founder of Paisabazaar.com.

Disappointed by the MCLR regime’s limited success, the RBI, in 2018, directed banks to switch to an external lending benchmark, so that the borrowers were better placed to reap the benefits of policy transformation. Following this, banks switched to the repo rate-linked lending regime, starting October 2019. Currently, almost all major banks in India offer home loans that are linked to the RBI’s repo rate.

Key facts about repo-rate linked home loans

Buyers taking a home loan liked with the repo rates or those switching their old home loans to it, must have clarity about certain facts about these loans.

Transmission is quicker: Any changes in the repo rate are likely to be reflected in your EMI outgo much faster.

“With repo-rate linked home loans, borrowers can expect a much faster transmission on to their loan rates. Also, such loans will be more transparent, as far as the rate-setting mechanism is concerned and should add more certainty to the borrowers, in anticipating their loan interest rates,” says Kukreja.

This also means, your home loan EMI will increase as and when the banking regulator makes any change in its key lending rate. “Consequently, repo rate-linked loans can work against buyers, during the rising interest rate regime, Kukreja warns.

Also, banks will ultimately decide the additional interest they would charge, on top of the repo rate on home loans. Even though the repo rate is currently at 6.50%, the cheapest available housing loan in the market current is at 8.50%, reflecting a difference of two percentage points.

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Changes to India’s repo rate since June 2000

Source: RBI

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