A worrying news is emerging from the banking front for crores of borrowers and middle class families of the country between the festive season and the quarters of the new financial year. Before the Monetary Policy Review Meeting (Monetary Policy Committee – MPC) of the Reserve Bank of India (RBI), there is a growing fear among financial markets, economists and banking experts that the central bank may once again increase the repo rate by 25 basis points (0.25%). If the committee headed by the Governor approves this increase in interest rates, then it will have a direct impact on all home loans, car loans, personal loans and education loans linked to the External Benchmark Lending Rate (EBLR) and Repo Linked Lending Rate (RLLR) of the banks.
The central bank often uses interest rates as a tough weapon to balance the volatility of the foreign exchange market and the flow of cash into the domestic economy. At a time when consumers are planning festive shopping, booking new houses and vehicles, a possible rise in interest rates could shake up their monthly household budgets. Any increase in repo rates is passed on directly to the pockets of retail customers by banks, which either increases their monthly EMIs or lengthens the loan tenure.
What are the circumstances before the Monetary Policy Committee of the Central Bank that are preparing the ground for increase in interest rates? Economic analysts have underlined 4 major reasons behind this:
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Food inflation and rise in vegetable prices: CPI (Consumer Price Index) based retail inflation continues to reflect persistent volatility in prices of food items, especially green vegetables, pulses, edible oils and spices. Supply chain pressures due to weather events and unbalanced rainfall have kept core inflation above the RBI’s medium-term target of 4 per cent. Until food inflation comes completely under control, the central bank avoids any relaxation in rates.
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Geopolitical tensions and crude oil surge: The deepening military crisis in West Asia and increasing attacks on the Red Sea maritime trade route have destabilized international crude oil prices. India imports more than 85% of its crude oil needs. Any increase in crude and freight charges in the international markets directly leads to imported inflation, to stop which monetary tightening is considered necessary.
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Tough stance of US Federal Reserve and global banks: The strength of the dollar index in global currency markets and the cautious stance adopted by the US Central Bank (US Fed) regarding interest rates impact emerging markets like India. If the interest rate differential between India and America decreases, then foreign institutional investors (FIIs) start withdrawing money from Indian markets and investing in dollar assets. RBI has to balance the interest rates to save the value of rupee from historical decline and to prevent capital outflow.
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Domestic demand and strong credit growth: The Indian economy has witnessed a steady growth in consumer demand, real estate sales and demand for unsecured retail loans. Excess liquidity in the economy due to excessive credit flow increases the risk of demand-pull inflation. Tightening interest rates is considered a natural step to protect asset quality and control excessive lending in the banking system.
If the Reserve Bank of India increases the repo rate by 25 basis points (0.25%) in the upcoming meeting, its direct impact will be visible on your existing and new loans. For example, if a person has taken a home loan of ₹30 lakh at an interest rate of 8.50% for a tenure of 20 years, his monthly EMI currently works out to be around ₹26,035.
As soon as banks pass-on the 0.25% increase in repo rate and increase the interest rate to 8.75%, the EMI will increase to approximately ₹26,511. This means there will be an additional burden of approximately ₹ 476 every month. This seemingly nominal increase of 0.25% adds up to a total additional interest burden of over ₹1.14 lakh on the borrower’s pocket over the entire tenure of 20 years. If the borrower does not increase the EMI, banks extend the loan tenure by several months, forcing the person to continue repaying the loan even as they approach retirement.
In this rising interest rate cycle, common consumers should make some practical changes to their financial strategy:
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Choose part-payment option: Deposit 5 to 10 percent of the principal amount as part payment using your bonus, savings or extra income. This results in a significant reduction in the loan tenure and total interest payable.
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Compare rates across banks: Check the spreads and margins of your existing bank. If any other financial institution in the market is offering home loan transfer facility at a lower interest rate, the option to switch can be considered.
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Balance of Fixed vs Floating: In a high interest rate cycle, it makes sense to stick to floating rates because when inflation is controlled and interest rates fall in the future, the immediate benefits accrue to floating rate customers.