What is Repo Rate and How it Affects Interest Rates

Repo rate is a powerful tool used by India’s central bank, the Reserve Bank of India (RBI), to maintain liquidity in the market and manage cash flow. The Monetary Policy Committee (MPC) of the RBI convenes bi-monthly to make changes to the repo rate according to economic conditions. It can be used to combat inflation, recession, induce cash flow, increase investment, etc. A hike or slash in the repo rate can have significant impacts on the economy, particularly the cost of borrowing credits. Thus, you must be aware of this term and what it implies for you as the borrower.

What is Repo Rate?

The repo rate is the rate at which commercial banks borrow from the RBI by selling security such as Treasury Bills to the central bank. Just like you, the borrower, borrow money from the bank by providing collateral and repaying the amount with an interest rate, commercial banks can also borrow money from the RBI in case of a cash crunch.

Here, the collateral is the Treasury Bills that commercial banks sell to the RBI, and the interest rate of borrowing is called the Repo Rate. However, the repo rate does not just affect the borrowing banks; it also affects the ordinary citizens of society.

How does the repo rate works?

The repo rate is the interest rate at which the Reserve Bank of India (RBI) lends short-term funds to commercial banks against government securities. When banks need to borrow money, they sell securities to the RBI with an agreement to repurchase them later at a slightly higher price. The difference in price reflects the repo rate. A lower repo rate makes borrowing cheaper, encouraging spending and investment, while a higher rate makes borrowing more expensive, helping to control inflation and slow down economic activity.

Impact of the repo rate on interest rates

Here's how the repo rate impacts interest rate:

Borrowing costs: A lower repo rate reduces the cost for banks to borrow funds, which often translates to lower interest rates on loans and credit for consumers and businesses. This can encourage borrowing and spending, boosting economic activity.

Deposit rates: Banks may also lower interest rates on deposits in response to a lower repo rate, as their cost of borrowing is reduced. This can impact returns on savings.- Inflation control: A higher repo rate increases borrowing costs, leading to higher interest rates on loans and credit. This can reduce borrowing and spending, helping control inflation by cooling down economic activity.

The relationship between repo rate and interest rates

The relationship between the repo rate paid by the bank to RBI and the interest rates paid by the borrower to the bank is directly proportional. The greater the repo rate, the higher will be the cost of borrowing. Let us understand this with two examples.

Scenario #1: RBI hikes repo rate

As of December 2020, the repo rate was 4%. Suppose that RBI increases this to 6%. This means that now, the cost of borrowing from the RBI has increased by 2% or 200 basis points for commercial banks. To compensate for a high cost of borrowing, banks will, in turn, charge a higher interest rate from their borrowers. As a result, loans will become expensive for citizens.

Scenario #2: RBI slashes repo rate

Alternatively, if the RBI slashes this rate from 4% to 3.75%, banks will be able to afford borrowing more easily than before. They will reduce the interest rates for loans and taking a loan from the bank will become cheaper for citizens.

In addition to affecting the interest rates on loan, the repo rate also impacts the returns on direct deposits. If there is a repo rate cut, you will earn a lower interest rate and vice versa.

Additional Read: How a change in repo rate impacts your loan EMIs

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Frequently asked questions

1. How does an increase in repo rate impact existing borrowers?

An increase in the repo rate usually leads to higher interest rates on loans. For existing borrowers with floating-rate loans, this means higher monthly EMIs or longer loan tenure.

2. How does a high repo rate impact credit card borrowers?

A high repo rate can result in increased interest rates on credit cards. Banks may raise these rates to compensate for the higher cost of borrowing from the RBI, making credit card debt more expensive for consumers.

3. How does a reduced repo rate help borrowers?

A reduced repo rate lowers the cost for banks to borrow from the RBI. This often leads to a decrease in interest rates on loans, making borrowing cheaper for consumers.

4. What is the difference between repo rate and reverse repo rate called?

The difference between the repo rate and the reverse repo rate is called the interest rate corridor.

5. What is the difference between the repo rate and the MCLR rate?

The repo rate is the rate at which the RBI lends money to commercial banks, while the MCLR (Marginal Cost of Funds Based Lending Rate) is the minimum interest rate that a bank can offer for loans.