Interest Rate Option (Form #D3: Fill & Download for Free

Lets understand the basics first.The Repo Rate is a tool through which a Central Bank (RBI in this case) controls the money supply in an economy. If Repo rate is increased, it provides disincentive to banks to borrow money from RBI, thereby effectively reducing the money supply in the economy. If decreased, on the other hand, it enables banks to borrow more money from RBI at reduced rates, effectively increasing the money supply.Control of money supply is crucial to deal with Inflation. In case of high inflation, RBI will increase the Repo Rate to arrest inflation by reducing the money supply. In case inflation decreases, RBI will lower the interest rates accordingly to increase the money supply.Now, when RBI decreases the Repo rate, the interest which Banks have to pay to RBI reduces. They in turn provide the benefit to consumers by reducing their interest rates on Loans. However, interest on loans isn't the only thing that is reduced. Also reduced is the interest rates of Saving Accounts, FDs, RDs, etc.How are businesses affected by this?Everyone wants their money to grow. That's why most of the money is kept in FDs, RDs, invested into stocks, mutual funds, invested into businesses, etc., wherein they can expect some returns. With interest rates being as high as 9-10% in FDs, RDs, etc., keeping the money in Banks is an attractive option for consumers , considering that this return is without any risk factor. With interest rates of banks going down, keeping money there becomes less attractive with low interest rates.Therefore, consumers start to look for investments with higher returns compared to Banks. This is where stock market steps in.Consumers start investing their money in stock markets, mutual funds, businesses ideas, start-ups, thereby providing capital to the business market. Note that I'm not saying they necessarily start their business & start-ups, but rather, just provide the capital in the form of investment, hoping for good returns. Although these investments have varied level of risks, the returns are also substantially higher as compared to safer investment options.This additional money provides impetus to the business sector, increasing the money supply, and promoting the manufacturing & service industry. Overall, this increases the Economic activity of the country, which is a good thing.Loan Interest Rate:You've said 'a 25 basis points cut in home loan rate will bring down EMIs by Rs 842 on a Rs 50 lakh loan tenure of 20 years'. I assume what you mean to say is that it will bring down the EMIs to Rs 842 per month per 1 lakh for 20 yrs for home loan. In 20 years, you'll only payback a little over 2 lakh for a loan of 50 lakh!! Hence the error:842 x 12 x 20 = 2,02,080Although, I think it is still wrong. For EMI to be Rs 842 per month per lakh for a loan period of 20 years, the interest rate would have to be 8.09%. However, the current home loan interest rates are 10.15%, which calls for a monthly EMI of Rs 975. Reducing Repo Rate by 25 basis points will lower the interest rates to maximum 9.95% if banks are willing to transfer the complete benefit to consumer.Ignoring those aspects, your question with relation to reduction on loan interest rates is, 'is it significant enough'?Yes, it is very significant. Lower interest rates, even if they may seem insignificant, drive more borrowing. The interest rate isn't reduced only for Housing loans, but for all loans, viz., infrastructure, education, businesses, etc.This borrowed money is not sitting idle but is being used to develop infrastructure, facilities, educate people, etc. Also, the money above, that is being pulled out of banks and being invested in other areas, fund various other businesses, projects, products, services, which raise the economic activity in the country, thereby increasing GDP of the country.Increase in GDP will in turn strengthen the currency of the country, further arresting inflation. This is the driving force for growth. It provides the conditions suitable for growth of any economy.Even stock market closed on a high due to this news. So how are they both related?Stock Market prices take 2 things into consideration:1. Actual results2. Anticipated resultsActual results broadly decide the general price of any share in the stock market. Anticipated results result in its periodic rise and fall based on the demand & supply principles.When RBI reduces/increases the Repo Rate, there is a speculation in the market about the probable effects. Since, reducing the Repo Rate is good for businesses, there is a speculation that the market would go up. Accordingly, there would be more buying of shares in the anticipation that market would go up at later stage. However, following the demand and supply theory, since the demand of shares in market increases, their price also increases.This is the reason why there is a rise in Stock Market Prices.Hope your question is answered. :)

hey anon !I take it that you know about MCLR or Marginal Cost of Funds based Lending, which has been made applicable w.e.f 1st April 2016 as a counter to the base rate system.Now, about how does MCLR benefits the ultimate consumer is a debatable topic and has to deal upon the type of loan you are indulged in (as mclr is not applicable on auto loans and personal loans) and is completely dependent upon the ongoing interest rate fixed by the RBII,though will try to form a clear pictureDr Raghuram Rajan, our beloved RBI governor (writing this answer on 5th sept ,so he is still our Rbi gov) cut the Repo Rates in the previous fiscal year so that to make loans cheaper for borrowers but banks haven't had started following the same while lending,so interst rates were still based upon the previous rates !Thanks to MCLR, the calculation of interest rates (though a bit complicated) will be based uponMarginal cost of fundsOperation expense of bankCost of carry in the CRRAnd, Tenor premiumexplaining the above,Marginal cost of funds depends uponBank rate interest (charged by banks from consumers)Repo Rate (charged by RBI from banks)Rate of Return on the capitalNow weights are assigned to it with a 92% weight to the sum of (1) and (2) and 8% to (3). Operting expense of bank is nothing but the daily cash requirement for running the bankCost of carry in the CRR means that banks have to take into account the amount of CRR blocked with them which they can't use, because CRR !Tenor Premium is about the time period a.k.a longer the duration of loan period,higher the premium.banks are allowed to charge a premium to the borrower for the risk (uncertainty) associated with lending for longer period.Now the RBI has issued guidelines for the banks so that they can pass on the benfit of a rate cut,down the lane . The main benefit coming out of the base of calculation of bothBanks would now charge you based upon the marginal cost of funds,by taking in account the repo, and tenor premium, so giving you a ‘reset period’ after which your loan rate will be revised plus the ‘spread’ banks levyComing back to the main answer, MCLR will benefit the consumers as now a rate cut in the repo will directly be reflected in the form of marginal costs of funds and customTaking an exampleFor instance, for salaried individuals, ICICI Bank has set a floating rate home loan at one-year MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will be 9.45% (9.20% +0.25%). This interest rate is valid till 30th April, 2016 (as given in the bank’s website). ICICI Bank has decided to set one-year MCLR as the benchmark rate for their home loans.Though the MCLR is reviewed monthly, your home loan will be reset every year automatically, depending on the agreement with the bank.So, if you take a Rs.50-lakh home loan on 10th April,2016, your home loan interest rate would be 9.45% . You have to pay EMI installments at this rate of interest for the next 12 months.Let’s say one-year MCLR gets revised to 9.% in April, 2017 and the spread remains the same then your home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread of 25 bps)But , the interest rates cannot be predicted to remain low forever, if they increase there will be a swift hike in the interest rate (MCLR) ! Anyway if you predict a rate cut in the near future, you can transfer your loan to a mclr from a base rate oneMany companies prefer being charged with a floating interest rate rather than a fixed one as they hint from guidelines about rate cuts and would be benefitted by oneIt is too early to say if the change in base rate will actually be completely passed on to consumers. Because, do remember that banks still have the option to set a ‘spread‘ on loans. Banks are free to determine the range of spread for a given category of borrower or type of loan. (For example, if the loan interest rate offered to you is 10.25% and the new base rate as per MCLR is say 10%, 0.25% is the spread)As far as banks are concerned, their margins might take a hit in the range of Rs 15,000 to Rs 22,000 crore assuming a 75 basis point decline (source – ICRA). Banks may lose when interest rates drop but will gain when rates increase. So, it all depends on how many instances of ‘rate cuts’ will happen in the future.MCLR is applicable for Banks only. Hence this is irrelevant to home loans offered by NBFCs (Non-Banking Financial Companies) like LIC Housing Finance, Dewan Housing (DHFL), HDFC, Indiabulls housing finance etcThanks for readingImages and example from : ReLakhs.com - Personal Finance Blog