Personal loans have emerged as the popular financial tool for securing instant access to funds for any purpose—financing a wedding, repairs to a house, payment of medical bills, or debt consolidation.
Few know, however, how closely such loans are linked to the monetary policy adopted by a nation’s central bank.
Such a policy tool is the repo rate, one of the key things to consider in setting the price of borrowing on personal loans. Here, we are introducing the repo rate, how it affects personal loans, and what you should know.
Learning about Personal Loans
A personal loan is an unsecured advance by a bank, credit union, or online lender to an individual on credit score. This raises the lending cost for consumers. For example, if repo rate is raised from 6% to 6.5%, banks can raise interest rates on personal loans from 12% to 12.5%.
Higher borrowing costs deter consumers from borrowing and decrease consumption in the economy. The lenders have the liberty of spending the money on almost anything and everything they wish without restriction, and hence the way to access finance quickly.
Yet, the rate of interest levied on the loan can play a huge role in the amount that is to be paid back, and therefore understanding interest rate drivers—such as the repo rate—is important.
What is the Repo Rate?
Repo rate” is a term used for the rate at which the central bank of a nation lends to commercial banks for a short duration, usually to address their liquidity needs. In India, the Reserve Bank of India decides the repo rate, and in the USA, the Federal Reserve runs a similar system. Commercial banks borrow funds from the central bank by holding government securities as collateral when there is a liquidity mismatch.
A borrowing for a short period incurs an interest charge known as the repo rate. Central banks, in turn, move this rate from time to time in a bid to regulate inflation, keep financial system liquidity within bounds, and stabilize economic growth.
Repo rate adjustments have a direct impact on the cost of borrowing for banks, with such a cost being passed on and influencing end-consumer interest rates in the form of those who avail personal loans, home loans, car loans, and other credit products.
How Repo Rate Influences Personal Loans
Repo rate is used as a reference point for the commercial banks and other financiers to determine interest rates. In what manner repo rate changes trickle down to personal loans can be better appreciated through the process below:
1. Cheaper Personal Loans Due to Reduced Repo Rates
This helps banks decrease the lending rate on individual consumer loans, making personal loans less expensive. A low repo rate is generally applied in times of economic recession to induce borrowing and boost spending.
As an illustration, if the RBI is reducing the repo rate by 50 basis points (0.5%), this is a call for commercial banks to share the benefits with consumers. Borrowers who take personal loans during this period are provided at lower interest rates, and therefore at lower equated monthly installments (EMIs).
2. Increase in Repo Rate Boosts Borrowing Charges
Conversely, when the central bank increases the repo rate—usually anticipating rising inflation—commercial banks pay higher borrowing charges. They thus raise the rate of interest on retail loans such as personal loans.
This raises the lending cost for consumers. For example, if repo rate is raised from 6% to 6.5%, banks can raise interest rates on personal loans from 12% to 12.5%. Higher borrowing costs deter consumers from borrowing and decrease consumption in the economy.
Reasons for Repo Rate Changes
Central banks’ decisions to increase the repo rate need to be understood by borrowers. The reasons are as follows:
1. Inflation Management
Central banks increase the repo rate in a bid to fight inflation. Increased cost of borrowing discourages extravagant expenditure and hence stabilizes prices. During periods of low inflation, the central bank can reduce the repo rate in an effort to stimulate borrowing and enhance the demand level in the economy.
2. Economic Growth
The repo rate can also act as an instrument of spurring economic growth when the economy is growing slowly. Lowering the repo rate lowers the cost of borrowing, facilitates greater loan disbursement, and spurs investment—infusing liquidity into the economy.
3. Global Economic Trends
Global economic conditions like foreign exchange rates and flows of foreign investment are also taken into account by central banks while adjusting repo rates. Domestic monetary policy decisions can be affected by adjustments in global interest rate policies.
Repo Rate Effect on Fixed and Floating Personal Loan Interest Rates
Personal loans provide fixed or floating interest rate options, and how the repo rate change impacts them depends on what kind of interest rate option is utilized by the borrower:
Fixed Interest Rate Loans
With fixed interest rate loans, the interest remains fixed throughout the loan term regardless of the repo rate changes. With fixed-rate loans, the borrowers neither benefit if the repo rate decreases nor suffer if repo rate rises.
Floating Interest Rate Loans
Floating interest rate loans, however, are immediately affected by fluctuations in repo rate. When the repo rate falls, EMIs on floating-rate personal loans decrease and become cheaper for borrowers. Increased repo rates bring about increased EMIs, though. Borrowers who are hopeful that repo rates will be lower in the future can utilize floating-rate loans frugally. There is risk involved with this strategy, however, as repo rates can go up with inflationary or economic stress.
Benefits and Drawbacks of Repo Rate Hike for Borrowers
Repo rate changes both have beneficial and detrimental effects on borrowers of personal loans.
Advantages
1. Lower EMIs: Substantially lower repo rates lower the price of personal loans, which lowers the financial liability of borrowers.
2. More Loans Available: Lower costs of borrowing make lenders receptive to more loan applications.
3. Economy Growth: Borrowers indirectly benefit from pushing policies that expand the economy.
Disadvantages
1. Higher Interest Cost: Higher repo rates generate higher EMIs, which are more expensive for borrowers.
2. Risk of Floating Rates: Floating-rate loan borrowers are vulnerable to uncertainty in the repayment cost.
3. Less Flexibility: Fixed-rate loans do not gain from declining repo rates.
Borrower Tips During Repo Rate Fluctuations
In times of fluctuating repo rates, borrowers can follow some tips so that they make well-informed decisions:
1. Keep Track of Repo Rate Announcements
Remain aware of repo rate changes by keeping track of central bank announcements. Data can guide you in formulating your borrowing strategy.
2. Compare the Highest Interest Rates
Compare personal loan offers from different lenders, particularly during times of repo rate changes, to obtain the best that is available.
3. Select Fixed or Floating Rates Wisely
Based on your personal financial positions and market situation, decide if you should go for a fixed or floating-rate loan.
4. Refinance Loans
If repo rates fall substantially, you can refinance your loan with an attempt to lower your EMIs and interest payout.
Conclusion
Repo rate plays an important role in determining the cost and terms of personal loan availability. The repo rate is used by central banks to stabilize economies, control inflation, and stimulate borrowing. Awareness of the repo rate and its effects equips borrowers to make individual loans prudently so that the cost of borrowing is kept low and benefits are maximum.
Whether the repo rates go up or down, the solution is to be aware and proceed accordingly depending on your financial objectives. Monitoring changes in monetary policy and comparing loan offers will leave borrowers better placed to obtain cheap personal loans, stretching their finances to the limit.