CRR, SLR, Repo Rate, Reverse Repo Rate and how it effects your Home loans:
Mr. Ajay while watching a business news channel came across a news item that there was a Repo rate cut of 25 basis points. Ajay was curious to know as to how this rate cut would impact his home loan. We often come across terms such as CRR, SLR, Repo Rate & Reverse Repo Rate but may not be aware of how a change in these rates could affect our finances. This post will help you understand these terms and their impact on home loans.
So, what is a basis point?
A Basis point mainly used in finance is a unit of measurement that depicts the percentage change in the rate or value of a financial instrument. One basis point is equivalent to one hundredth of a percent or 0.01%. In a simpler form, 1% is equal to 100 basis points. So, a reduction of 25 basis points means there is a decrease of 0.25%, or the value of the instrument has been reduced by 0.25%.
But, why do RBI changes the interest rates?
RBIs primary objective is to maintain monetary stability i.e. moderate and stable inflation in India. It uses monetary policy to control the money supply in the economy and the price that the economy has to pay to borrow the money i.e. the cost of credit . The two majorly affected parameters by these two factors are Growth and Inflation. So, to control inflation and growth in the economy, it uses tools such as Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate and changes the rates.
Also read: Inflation and the Real rate of return
Cash Reserve Ratio (CRR)
Banks in India are required to confine a certain portion of its deposits with RBI in the form of cash. The ratio in wh ich the banks have to keep the portion of its deposits as cash is determined by RBI and is termed as Cash Reserve Ratio (CRR). Banks don’t earn interest on this portion of money deposited with RBI.
So for instance, a bank gets a deposit of Rs. 10,000 and the prevailing CRR is 4%, then the bank has to deposit Rs. 400 with RBI i.e. 4% of Rs. 10,000. The bank can only use the remaining amount i.e. Rs. 9,600 (Rs. 10,000 – Rs. 400) for any investment, lending or credit purpose, it cannot use Rs. 400 deposited with RBI.
Impact of CRR
If the CRR is high, banks have to keep more money with RBI and also the cost to the banks will be higher. As a result, you have to pay a higher rate of interest on your borrowings from the banks. On the other hand, if RBI cuts the CRR, the cost to banks come down and if banks reduce their basic lending rate/ base rate, then your cost to borrowings also comes down i.e. banks reduces the interest rate on your borrowings.
• All your loans with floating rate of interest availed post April 01, 2016 are linked to the marginal cost of funds based lending rate (MCLR). On the other hand, all the loans taken before April 01, 2016 are linked to the Base rate.
• The base rate is the least rate below which the banks are not allowed to lend money to borrowers. Banks consider various other factors such as credit to deposit ratios before deciding on reducing the base rate.
Statutory Liquidity Ratio (SLR)
Apart from CRR, banks are also required to hold a certain percentage of their Net Demand and Time Liabilities in the form of approved securities such as government bonds, gold, cash, etc. This portion of the deposit is known as Statutory Liquidity Ratio (SLR). It is done to ensure that banks have sufficient funds available to pay back to its customers who may have the immediate requirement to withdraw funds from their accounts or encash their deposits. SLR stands at 20.75% as of November 05, 2016.
So, let say a bank gets a deposit of Rs. 10,000. With the prevailing SLR of 20.75%, the bank has to invest Rs. 2,075 in government securities with RBI.
Impact of SLR
If the SLR increases, it restricts the bank’s lending capacity and helps in controlling the inflation by soaking the liquidity from the market. Consequently, banks will have less money available to lend, and they will charge higher interest rates on loans to keep up with their profit margin.
Repo rate also known as repurchase agreement is the rate at which banks borrow money from RBI by selling its approved securities to RBI. Usually, the money is borrowed for a shorter duration of up to 2 weeks. This repo rate is managed by RBI and is a cost of credit for the banks.
Repo rate as of November 05, 2016 is 6.25%. Let say a bank borrows Rs. 10,000 from RBI, then at the prevailing repo rate i.e. 6.25% the bank have to pay Rs. 625 as interest to RBI. The increase in repo rate increases the cost of short-term money for banks and vice versa. Also, higher repo rate may result in the slowdown of the economic growth.
Reverse Repo Rate
It is the rate at which bank deposits its surplus funds with RBI for a shorter duration. Banks does this when they do not have any investment or lending options available to them. RBI uses reverse repo rate when there is excessive money floating in the banking system. RBI pays interest on such surplus funds deposited by banks. Prevailing reverse repo rate as of November 05, 2016 is 5.75%. So, if the bank deposits Rs. 10,000 with RBI, it will earn Rs. 575 as interest on the deposit.
Also read: Pre-EMI Vs EMI
• If RBI cuts the repo rate, banks may charge a lower rate of interest on your home loans. However, this does not necessarily hold true as the interest rates charged on the loans are linked to the base rate/MCLR. Hence, the interest rate on the existing loans may only come down when the banks reduce their base rate/MCLR. So, until there is a cut in the base rate/MCLR, don’t assume that the cut in the repo rate will reduce your cost of borrowings.
• If there is a cut in the interest rate on your borrowings, by default banks reduces the loan tenure of your existing loans and not EMIs i.e. your EMI remains the same. The reduction in the interest rate makes a significant difference if the remaining loan tenure is longer. If you want to get your EMI lowered, you need to contact your bank or the lender for the revision of the terms & conditions on your borrowings and have to submit the revised ECS mandate.
• If you have a loan at a fixed interest rate, the rate cut will not have any impact your borrowings.
Even though a 0.25% rate cut does not look big, it does make a huge impact on your savings over a longer tenure. Below table illustrates the impact of the rate cut on various loan amounts at 9.5% and 9.25% for loan tenure of 20 years.
The reduction in interest rates makes a positive impact on your borrowings provided your banks also deduct the rates. Do remember, rate cut does not always mean that your EMI will come down automatically. You have to check with your bank or lender for the same.