1 TakeBestLoans.com Factors which Impact Loan Interest Rates & How to decide Fixed v/s Floating Interest Rates?

2 Index  Definitions Definitions  Tools available with RBI and their functions Tools available with RBI and their functions  RBI and its toolsRBI and its tools  Repo Rate and Inflation Repo Rate and Inflation  Repo Rate and GDP Repo Rate and GDP  Conclusion Conclusion TakeBestLoans.com

3 Lets go through some Definitions Repo rate – Repo rate is the interest rate at which banks borrow money from RBI. Currently 8%. There is a certain limit up to which banks can borrow from RBI at repo rate. MSF rate – Marginal standing facility rate is the rate at which banks borrow from RBI once the borrowing limit under the repo rate is exhausted. CRR – (Cash reserve ratio) – Certain amount of cash is to be maintained by banks to pay up the depositors at any given point. SLR – (Statutory Liquidity Ratio)- RBI decides a certain percentage of total assets that banks have to invest in low risk government bonds mandatorily. TakeBestLoans.com

4 Lets go through some Definitions TakeBestLoans.com WPI (Wholesale Price Index) - WPI inflation is calculated on the basis of increase in whole prices of commodities. CPI (Consumer Price Index) - CPI is the inflation that is met by the end product or service user. It is the increase in the prices of goods & services which are witnessed by the common man. WPI Core - It is the WPI inflation which excludes food, reason being food is always at the higher end of inflation. Excluding it gives better estimate of average price changes in commodities.

5 Lets go through some Definitions Gross Domestic Production - GDP is the total amount of goods & services produced within the country. Therefore GDP growth shows overall increase in the capacity of production of a certain country which can be a measure of economic growth of a country. Index of Industrial production - IIP is another measure to estimate economic progress of a country. It measures the increase or decrease in the production activity of a country. Inflation - Inflation is the rise in prices of goods & services. When the demand for goods & services goes up and supply is not able to keep up with demand. Prices for goods rise as there is only limited supply. This rise in price is called inflation. TakeBestLoans.com

6 Simple overview about banks and loans 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 put the money in fixed deposit in the bank giving you a 8% interest return. The bank Lends out that 1,000 to another person seeking finance at a 12% interest rate. So bank stands to make the 4% additional interest gain, after paying you 8% interest. That’s how banks works. Lets say the 12% is the base rate for this particular bank. TakeBestLoans.com

7 Tools available with RBI and their functions Here are the tools Reserve Bank of India (RBI) uses to influence the economy of a country. Repo rate- When the economy is bottomed out RBI decreases the repo rate so as to decrease the base rate of the banks. So lets say the 12% interest rate loan is available for 10% now. Imagine you have a home loan which had a 20,000 EMI, now it only costs you 15,000 per month. This hikes the demand for loans as they are cheaper now. Vice Versa, in a scenario where the inflation in country is high RBI increases the repo rate which shoots up the base rate of banks. So the 12% jumps to 14%. So your home loans which cost you 20,000 EMI earlier now costs you 25,000. In this case fewer people will opt for housing loan as it is more expensive now. Similarly in the economy as whole demand for goods & services drops down because of less money supply in the economy. Now fewer people have capacity to purchase commodities without those costly loans. This results in drop in demand for commodities and thus helps reducing inflation. TakeBestLoans.com

8 Tools available with RBI and their functions CRR- According to the RBI guidelines, banks must maintain a certain CRR fixed by RBI. The motive behind this is that if at any given time more than expected depositors show up to withdraw their deposits the banks should be able to generate enough cash to satisfy the demands. Increasing or lowering CRR helps RBI in maintaining money supply in the economy. Suppose if RBI increases the CRR, bank would have to keep more cash in reserve with them & thus they may lend out only lesser. SLR- Money invested in low risk assets such as government bonds serves the purpose same purpose as CRR. This can be explained thinking of an extreme scenario where bank has losses on loan advances and thus cannot pay up the depositors money. By selling the government bonds banks can come up with cash to pay off depositors. SLR is also to be maintained by the banks as per RBI guidelines. TakeBestLoans.com

9 Tools available with RBI and their functions MSF rate - MSF rate as explained before is the penal borrowing rate which banks use when they exhaust the borrowing limit under Repo rate. Increasing or decreasing MSF impacts on the banks base rate. Similar to the repo rate hiking or lowering the MSF has similar impacts on the base rate of banks. Therefore its another tool RBI uses to control the money supply in the market. Reverse Repo- An increase in the reverse repo means commercial banks gets more interest when they lend RBI. This results in decrease of money supply in the market. Vice versa when the economy is strained & RBI wants to increase the money supply in the market, it decreases the reverse repo rate. TakeBestLoans.com

10 RBI and its tools RBI uses the tools as discussed earlier to control Inflation, GDP and even other factors. Repo rate is the most relevant indicator for the determination of bank interest rates. Repo rate, Reverse repo, MSF, SLR and CRR all these rates mostly flow together. MSF was introduced in 2011, so the banks can get more money if required and is supposed to be 1% higher than repo rate, but in 2013 it was 3% because of falling rupee value. SLR and CRR are used to control flow of money in the market and for contingency purpose. Since 2011 the SLR and CRR has also been decreasing from 24% and 6% to 22% and 4% in 2014 respectively. TakeBestLoans.com

11 TakeBestLoans.com RBI and its tools

12 Repo Rate and Inflation 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 is also closely following CPI. WPI neglects the end users, but on the other hand CPI considers end users i.e. the consumers. CPI is used by majority of the countries. Therefore, the WPI inflation is lower as compared to CPI, which can be seen the below graph. In the graph we can see the repo rate is above WPI through out and repo falls when WPI goes down and vice versa. TakeBestLoans.com

13 Repo Rate and inflation But we can see the WPI is going down but repo rate is constant in the end of 2013 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 started falling after. WPI inflation is the lowest since 2011 at 3.74% but RBI is also focusing on CPI, so 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 January 2015 and 6% till The CPI for August 2014 is 7.8% and RBI expects it to be constant. TakeBestLoans.com

14 Repo Rate and Inflation TakeBestLoans.com

15 Repo Rate and GDP GDP growth has not been very good since after 2008 recession. The GDP had grown in and but since then decreasing again. GDP growth was recorded the lowest for 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. TakeBestLoans.com

16 Repo Rate and GDP When the GDP started growing after recession, the repo rate again was low and GDP % high Since December 2013 the repo rate has been increased even though there is slight increase in GDP. The Reason for not decreasing repo rate is, RBI is more focused on controlling inflation for the benefit of common man. TakeBestLoans.com

17 Repo Rate and GDP TakeBestLoans.com

18 Conclusion The bank interest rate will change when repo rate changes. It is expected that RBI may soon decrease the Repo Rates in 2015 (hence loan interest rates should also come down eventually in 2015) So it is currently desirable to go for floating rates rather than fixed rates for taking any loan. Besides, there are currently no pre payment penalties for floating rate housing loans If you have taken fixed rate loan, when the repo rate goes down (base rate of bank may reduce and hence also the loan interest rates) you will be paying the same interest rates (rather than lower interest rates). TakeBestLoans.com

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