The Central Bank of a country creates a framework for the economy. All lenders and financial institutions follow the rules and guidelines set by the central bank. Every two years the central bank reviews the economy and analyzes whether their targets are being met or not. These goals are mostly related to keeping inflation under control. If the plan is not on track, they plan and make modifications to achieve their goal.
In India, the central bank is also known as the Reserve Bank of India (RBI). RBI plans and forecasts banking policies. They recently came into limelight when they increased the repo rate by 25 basis points. This is the second time in four years that the RBI has increased the repo rate. Today the rate is 6.50% which is 50 basis points higher than 4 years ago i.e. 6.00%.
What is repo rate?
A repo rate is the rate at which the central bank lends money to commercial banks when they fall short of maintaining an appropriate balance. This balance is decided by the Central Bank (RBI). When a commercial bank cannot maintain such a balance, they can borrow money from the RBI at interest.
Why did RBI increase the repo rate?
RBI increased the rate to achieve its target of maintaining inflation around 4%. An increase in this rate triggers a chain of events. Banks will borrow less money from RBI due to higher repo rate. So they would be short of funds to lend to the customer. They will lend the rest of the money at a higher rate of interest. Hence many customers avoid taking loans which reduces the demand. This will control inflation in the long run.
Should this rate increase be a cause for concern?
Yes. When RBI increases the repo rate, the commercial banks increase the interest rate on various loans like personal loan, home loan etc. This effect is then passed on to the customer as with the increase in the interest rate, the EMI will increase. Yes, if the interest rate of your loan is floating, the EMI will be revised depending on the market conditions and also if the repo rate is increased by RBI. Therefore, the debt burden on the customer will now be more expensive than before. With the increasing debt burden, it may be wise to consider prepaying the loan partially/fully.
