RBI policy: How a repo rate hike/cut impacts your home loans and EMIs

The Reserve Bank of India is expected to keep the repo rate unchanged at 6.50% on Thursday, for a second straight month, signaling that inflation could cool further in the months ahead.

 But how does a repo rate hike impact your home loan EMIs?
 

The central bank increased the repo rate by 250 basis points since May 2022. In April, the RBI left the rate unchanged. But through the year, lending institutions increase the interest rates of home loans and this has resulted in higher EMI and a lower home loan amount for borrowers.

Every time the RBI makes a change in the repo rate, banks tell home buyers that the cost of borrowing will become higher/lower because of the upwards/downward change in the lending rate.

What is the repo rate?

The repo rate is the interest rate at which the RBI lends to the banks. The term ‘repo’ is short for repurchasing option or repurchase agreement. Under the arrangement, scheduled commercial banks provide securities such as treasury bills or gold to the RBI for availing overnight credit in case of liquidity shortfall.

The repo rate is also an effective tool for RBI to control inflation

 In case of high inflation, the RBI increases the repo rate to discourage banks from borrowing. This eventually reduces the liquidity in the economy, subsequently taming the high inflation. And when inflation falls,  the repo rate is cut to prompt banks to borrow more credit, which ultimately increases the supply in the market, triggering  investment activity.

How does repo rate affect loans taken by you?

When the RBI lowers the repo rate, the cost of borrowing for banks goes down. Banks are expected to pass on this benefit to the consumers. Conversely, home loan interest rates go up with the RBI making an upwards tweak in its lending rate. Apart from home loans, the rise in repo rate increases the rate of interest on all types of loans such as personal Loans, business Loans, car loans etc.

The EBLR serves as a benchmark rate that determines the interest rate applicable to the loan. So, with the hike in repo rate, all existing home loans on floating rates of interest became expensive.

"Buyers who take out a house loan tied to repo rates or those who move from their existing home loans to it need to understand certain details about these loans. Transmissions are faster. Any adjustments to the repo rate will likely be reflected in your EMI outlay considerably more quickly. This also implies that your house loan EMI would rise if the banking authority modifies its benchmark lending rate," said ClearTax.

 A 40 basis points increase in EBLR would result in a corresponding increase in the interest rate on home loans. Therefore, existing borrowers with floating rate home loans linked to the EBLR would experience an increase in their loan repayments, leading to an impact on their monthly budget and disposable income. Some borrowers may need to adjust their expenses or partially prepay loans to accommodate the increased EMIs, explained Adhil Shetty of BankBazaar.com

Let’s say you have taken out a home loan of Rs 3,000,000 for tenure of 15 years. If your bank is offering an interest rate of 8.75%, you would be paying a monthly EMI of approximately Rs 29,983. Now, if the interest rate is reduced by 25bps, and if the bank passes on this benefit (in entirety) to you, the borrower, your monthly EMI amount comes down to Rs 29,542. While this may not seem like a huge reduction at face value, you could end up saving approximately Rs 80,000 throughout the tenure of the loan.

Higher interest rates also imply higher repayment obligations, which could lead to a decrease in the amount that borrowers are eligible to borrow from the lender. This could impact homebuyers’ ability to afford the desired property or reduce the loan amount they can obtain.

How EMIs have gotten more expensive
A 2.5 percent hike in repo rate implies that the e
quated monthly installments (EMIs) for borrowers have gone up by approximately 16 percent in case of a 15-year loan, 20 percent in case of a 20-year loan, and 26.5 percent in case of a 30-year loan.

"Consider someone who may have borrowed at the rock bottom rate of 6.50 last year. With a 2.5 percentage points increase taking their rate to 9.00, their per-lakh EMI on a 20-year loan would rise from Rs 746 to Rs 900 – a 20% leap within a year," said BankBazaar.

"To minimise the increased interest burden, borrowers can prepay one extra EMI every year. They can also prepay 5-10 per cent of the loan every year if their income permits. Lastly, prepaying 5-10 per cent of the loan balance every year will also significantly bring down the overall repayment cost. If the interest is still on the higher side, you can opt for refinancing," said Shetty.

How can one reduce the home loan interest?

One option is to choose a shorter tenure – For long term loans, though the EMI is less, the overall cost of the loan drastically increases because you are paying interest for a longer period of time. So, choose shorter tenures as the interest amount will get lower with time.

Voluntary EMI hike

For example, if your regular EMI is Rs 50,000 but you voluntarily step it up to Rs 55,000, the additional Rs 5000 is adjusted against the loan principal. Shetty believes  an EMI hike is an achievable hack that provides the same effect as the lump-sum pre-payment in reducing the loan tenure.

The difference between floating and fixed interest rates

In a fixed rate loan, the interest rate is fixed at the time of taking the home loan. Apart from a regular fixed rate product where the rate of interest is constant over the entire term of the loan, there are variants available which allow you to fix your interest rate for specific periods of 2, 3 or 10 years and is available with the right of reset by the lender at any point in time.

According to HDFC, one should opt for a fixed interest rate when:

1.  You are comfortable with the EMI you are committing to pay. It should ideally not exceed 25-30% of your take-home monthly income.
2. You perceive a scenario of rising interest rates in the future and hence, would like to lock in your home loan at the existing rate.
3. If interest rates have come down recently and you are comfortable with the current level of interest rates, lock in at this rate with a fixed rate loan.

Floating interest rate: These loans are linked to the lender’s benchmark rate, which, in turn, moves in sync with the market interest rate. If there is a change in the benchmark rate, the interest rate on the loan also changes proportionately.

You should opt for a floating rate home loan in the following circumstances:

1. If you are expecting interest rates in general to fall over time, opting for a floating rate loan in such a scenario will result in the interest rate applicable to your loan falling too, thereby reducing the cost of your loan.
2. Floating rate loans are suitable for those who are unsure about interest rate movements and would prefer to go with the market rates.
3. If you are looking for some savings on your interest cost in the near term, floating rate loans are usually set at a marginally lower rate than fixed rate loans thereby giving you some benefit in terms of cost of your loan.

The key difference is that in a fixed rate loan, the bank bears the risk of future rates going up, while in a floating rate loan, the borrower bears the risk that the future rates will go up. Fixed rate loans may be priced higher than floating rate ones, if the bank believes rates will rise. 

Note: Rates that vary with tenures or credit score within the specified loan amounts are indicated as a range. Fixed interest rates may be subject to a revision after a specified tenure. Rates may also apply only for a definite period and change to floating thereafter. Data taken from respective bank’s website as on Jun 02, 2023. Contributed by BankBazaar.com.

How have the rate hikes impacted the housing market so far?

"In terms of real estate, the implication of the rate hike on home loan demand has been minimal so far. Residential demand has remained upbeat indicating strong consumer preference towards home ownership despite high interest rate and inflation over the last one year. However, with economic growth facing headwinds from global slowdown, and the full impact of the high interest rates yet to be seen, we remain cautious of the impact on housing market," said Shishir Baijal, Chairman and Managing Director, Knight Frank India. 

What if the RBI does not change the repo rate?
 

 When the RBI keeps the repo rate unchanged, it doesn’t have a significant impact on home loans. This is because the cost of funds for lending institutions remains stable, thus the interest rate for loans, too, remains the same.

So, if you have an existing home loan, a repo rate pause won’t affect your EMIs. But, if you have a floating rate loan, you may benefit from a rate pause.

"A repo rate pause signals that the RBI is maintaining a status quo until the economy improves substantially. A rate hike, on the other hand, means that the cost of funds for banks will increase, which will then drive up EMIs for home loan borrowers. For example, if you have a floating rate home loan, a rate hike may drive up your loan rate and EMIs. Higher EMIs can reduce a borrower’s disposable income and affect their consumption pattern," said Shetty.

Home loan borrowers can benefit by keeping track of repo rate movements and choosing a home loan scheme accordingly.