The country's central bank - Reserve Bank of India is the deciding authority of the repo rate and this is subject to change from time to time. The repo rate will have an important bearing on the financials and hence it is mandatory to understand to know everything related to repo rate and its effect on the equated monthly instalment (EMI).
Before understanding the relationship between the repo rate and equated monthly instalments, let's first understand their meaning in brief.
What is a Repo Rate?
The repo rate is a rate at which commercial banks in India will borrow money from the Reserve Bank of India (RBI) whenever they face a shortage of funds. So, the repo rate is the interest rate charged by the RBI for commercial banks for lending funds.
The rate is primarily used by the monetary authorities to control the inflation rate in the country.
What is a Repo Rate?
Whenever inflation rates shoot up, the central banks will hike the repo rates. The move is adopted to discourage commercial banks from borrowing funds which in turn will reduce the supply of money in the economy and bring down the inflation rate.
Suppose, there is a fall in inflation rates, then the RBI may cut the repo rates as this will act as an incentive for commercial banks to borrow more funds from RBI and the same will be passed on to the customers thus increasing the money supply in the market.
The change in the repo rate will affect the equated monthly instalments. Before understanding the interconnectivity between the repo rate and EMI, we will know the meaning of equated monthly instalments.
What is Equated Monthly Installments (EMI)?
EMI is the abbreviation of the word Equated Monthly Installments. When a borrower takes a loan from the bank (lender), then the borrower will have to pay back the borrowed money in equated monthly instalments along with interest.
Each of these EMI consists of principal amount and interest accrued on the loan amount. Most of the banks in India will first try to recover as much of interest amount as possible during the first half of the loan tenure.
This is the reason as to why a borrower will end up paying high EMIs initially and as the loan tenure tapers, the EMI amount repaid by the borrower will increase and the interest amount will reduce gradually.
How does a change in Repo Rate affect EMI?
When the Reserve Bank of India cuts the repo rate, the banks will be expected to pass on the benefit to the customers by lowering interest rates. So, the interest rates on loans offered to the customers will come down which in turn will shrink the EMI amount.
In the same way, whenever the Reserve Bank hikes the repo rate, the interest rate on loans will be raised, making loans expensive for customers. Most of the commercial banks will borrow funds from the RBI at higher prices and hence the banks will hike interest rates of loans offered to customers.
As a general observation, whenever the RBI trims down repo rates, banks will take their own time to reduce the lending rates. But if the central bank raises the repo rate, then the banks will bump up their lending rates instantly, overnight.
Hence the central bank has come up with an MCLR regime with an agenda to change the function of the commercial banks. MCLR stands for Marginal Cost of Funds based Lending Rate, it is the minimum lending rate below which a bank will not be permitted to lend. The previously followed base rate system which was used for determining the lending rates for commercial banks are replaced with the MCLR.