The Central Bank of a country creates a framework for the economy. All the lenders and financing institutions follow the rules and guidelines set by the central bank. Every couple of years the central bank reviews the economy and analyses if their goals are being met or no. These goals are mostly related to keeping inflation in check. If the plan is not on track, they plan and make amends in order to achieve their target.
In India, the central bank is also known as the Reserve Bank of India (RBI). The RBI plans and forecasts banking policies. They recently came into light when they increased the repo rate by 25 basis points. This is the second time in 4 years that the RBI has increased the repo rate. Today the rate stands at 6.50% which is 50 basis points higher than what it was 4 years ago i.e. 6.00%.
What is a Repo Rate?
A repo rate is the rate at which the central bank lends money to the commercial banks when they fall short of maintaining a suitable balance. This balance is decided by the central bank (RBI). When a commercial bank cannot maintain such a balance, they can borrow the money from the RBI on interest.
Why did RBI increase the Repo rate?
RBI increased the rate in order to achieve their target of maintaining inflation around 4%. By hiking this rate, a chain of events unfold. Banks will borrow less money from the RBI as the repo rate is high. Hence they will have shortage of funds to lend to the customer. They will lend the remaining money on a higher rate of interest. Hence many customers will avoid taking a loan ensuring demand is reduced. This will curb inflation in the long run.
Should the increase in this rate be a cause of worrying?
Yes. When RBI increases the Repo rate, the commercial banks increase the rate of interest on different loans like personal loans, home loans etc. This impact is then faced by the customer as with the increase in interest rate, the EMI will increase. Yes, if your loan has a floating rate of interest, then the EMI will be revised by market conditions and also when the RBI increases the repo rate. Hence the debt burden on the customer will now be dearer than before. With the debt burden increasing, it might be wise to consider prepaying loans partly/fully.