why and how loan interest rates change

8/10/2019 Why and How Loan Interest Rates Change

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Factors which Impact Lo

Interest Rates

&How to decide Fixed v/s Flo

Interest Rates?


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Index

Definitions

Tools available with RBI and their functions

RBI and its tools

Repo Rate and Inflation

Repo Rate and GDP

Conclusion

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Lets go through someDefinitions

Repo rate Repo rate is the interest rate at which banks borrow

from RBI. Currently 8%. There is a certain limit up to which baborrow from RBI at repo rate.

MSF rateMarginal standing facilityrate is the rate at which banksfrom RBI once the borrowing limit under the repo rate is exhausted.

CRR (Cash reserve ratio)Certain amount of cash is to be maintabanks to pay up the depositors at any given point.

SLR(Statutory Liquidity Ratio)- RBI decides a certain percentage assets that banks have to invest in low risk government bonds mand

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WPI (Wholesale Price Index) - WPI inflation is calculated on the increase in whole prices of commodities.

CPI (Consumer Price Index) - CPI is the inflation that is met by

product or service user. It is the increase in the prices of goods &

which are witnessed by the common man.

WPI Core - It is the WPI inflation which excludes food, reason beingalways at the higher end of inflation. Excluding it gives better est

average price changes in commodities.


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Gross Domestic Production - GDP is the total amount of goods &

produced within the country. Therefore GDP growth shows overall in the capacity of production of a certain country which can be a me

economic growth of a country.

Index of Industrial production- IIP is another measure to estimate e

progress of a country. It measures the increase or decrease in the pr

activity of a country. Inflation - Inflation is the rise in prices of goods & services. W

demand for goods & services goes up and supply is not able to keep

demand. Prices for goods rise as there is only limited supply. This rise

is called inflation.

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Simple overview about banks andloans

Before going into details lets get a basic idea of what bank does.

Lets imagine a scenario where you walk into a bank with 1,000 and

money in fixed deposit in the bank giving you a 8% interest return. T

Lends out that 1,000 to another person seeking finance at a 12%

rate. So bank stands to make the 4% additional interest gain, after pa

8% interest. Thats how banks works. Lets say the 12% is the basethis particular bank.

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Tools available with RBI and theirfunctions

Here are the tools Reserve Bank of India (RBI) uses to influence th

country.

Repo rate- When the economy is bottomed out RBI decreases the redecrease the base rate of the banks. So lets say the 12% interest rate

for 10% now. Imagine you have a home loan which had a 20,000 EMI,

you 15,000 per month. This hikes the demand for loans as they are ch

Versa, in a scenario where the inflation in country is high RBI increase

which shoots up the base rate of banks. So the 12% jumps to 14%. So y

which cost you 20,000 EMI earlier now costs you 25,000. In this ca

will opt for housing loan as it is more expensive now. Similarly in the ec

demand for goods & services drops down because of less money

economy. Now fewer people have capacity to purchase commoditie

costly loans. This results in drop in demand for commodities and thu

inflation.

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CRR- According to the RBI guidelines, banks must maintain a certain

by RBI. The motive behind this is that if at any given time more than

depositors show up to withdraw their deposits the banks should bgenerate enough cash to satisfy the demands. Increasing or lowering

RBI in maintaining money supply in the economy. Suppose if RBI incr

CRR, bank would have to keep more cash in reserve with them &

may lend out only lesser.

SLR-Money invested in low risk assets such as government bonds s

purpose same purpose as CRR. This can be explained thinking of an

scenario where bank has losses on loan advances and thus cannot p

depositors money. By selling the government bonds banks can com

cash to pay off depositors. SLR is also to be maintained by the banks

guidelines.

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MSF rate - MSF rate as explained before is the penal borrowing ra

banks use when they exhaust the borrowing limit under ReIncreasing or decreasing MSF impacts on the banks base rate. Simila

repo rate hiking or lowering the MSF has similar impacts on the bas

banks. Therefore its another tool RBI uses to control the money supp

market.

Reverse Repo- An increase in the reverse repo means commercial ba

more interest when they lend RBI. This results in decrease of money s

the market. Vice versa when the economy is strained & RBI wants to

the money supply in the market, it decreases the reverse repo rate.

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RBI and its tools

RBI uses the tools as discussed earlier to control Inflation, GDP a

factors.

Repo rate is the most relevant indicator for the determination of bank

Repo rate, Reverse repo, MSF, SLR and CRR all these rates mostly flow

MSF was introduced in 2011, so the banks can get more money if r

supposed to be 1% higher than repo rate, but in 2013 it was 3% bec

rupee value.

SLR and CRR are used to control flow of money in the market and fpurpose.

Since 2011 the SLR and CRR has also been decreasing from 24% and

4% in 2014 respectively.

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2

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May2011

Jun2011

Jul2011

Aug2011

Sep2011

Oct2011

Nov2011

Dec2011

Jan2012

Feb2012

Mar2012

Apr2012

May2012

Jun2012

Jul2012

Aug2012

Sep2012

Oct2012

Nov2012

Dec2012

Jan2013

Feb2013

Mar2013

Apr2013

May2013

Jun2013

Jul2013

Aug2013

Sep2013

Oct2013

Nov2013

Dec2013

Jan2014

Feb2014

Mar2014

Apr2014

May2014

Jun2014

J l 2 0 1 4

Percentage%

RBI Tools

RBI and its tools


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Inflation has always been a major concern for RBI.

Inflation is calculated on WPI or CPI. In India, inflation is primarily referenced on WPI, but since 2013 RBI

following CPI.

WPI neglects the end users, but on the other hand CPI considers end

consumers. CPI is used by majority of the countries.

Therefore, the WPI inflation is lower as compared to CPI, which cabelow graph.

In the graph we can see the repo rate is above WPI through out and r

WPI goes down and vice versa.

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Repo Rate and inflation

But we can see the WPI is going down but repo rate is constant in the e

and increased instead of lowering in January 2014 (to control CPI).

CPI and WPI was at 11.16% and 7.75% in November 2013, and sta

after.

WPI inflation is the lowest since 2011 at 3.74% but RBI is also focusing

in January 2014 the repo was increased to 8% from 7.75%.

CPI inflation has come down and the RBI has set target of 8% till Jan

and 6% till 2016.

The CPI for August 2014 is 7.8% and RBI expects it to be constant.

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Repo Rate and GDP GDP growth has not been very good since after 2008

recession. The GDP had grown in 2009-10 and 2010-

11 but since then decreasing again. GDP growth was recorded the lowest for 2012-13 at

4.47%.

A low Repo rate helps to push GDP up (inverse

relation). This happens because low interest rate will

allow people to borrow and production in India will

increase which will push our GDP up.

GDP and repo rate from September 2008 to February

2009 went down together because of 2008 recession.

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0.00 2.00 4.00

2013-14

2012-13

2011-12

2010-11

2009-10

2008-09

2007-08

GDP Gro


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Repo Rate and GDP

When the GDP started growing after recession, the repo rate againand GDP % high

Since December 2013 the repo rate has been increased even thoug

slight increase in GDP.

The Reason for not decreasing repo rate is, RBI is more focused on c

inflation for the benefit of common man.

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Repo Rate and GDP

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Repo Rate & GDP Growth

Repo Rate % GDP %


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ConclusionThe bank interest rate will change when repo rate changes.

It is expected that RBI may soon decrease the Repo Rates in 2015 (he

interest rates should also come down eventually in 2015)

So it is currently desirable to go for floating rates rather than fixed

taking any loan.

Besides, there are currently no pre payment penalties for float

housing loans

If you have taken fixed rate loan, when the repo rate goes down (base

bank may reduce and hence also the loan interest rates) you will b

the same interest rates (rather than lower interest rates).

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