Repo Rate vs Home Loan Interest Rates: Understanding The Differences

Commerce students are known to have an edge when it comes to economics and have a good understanding of the functioning of an economy. It’s fair to say they learn more about banking institutions and their functioning as well. 

You’re probably wondering why I’m talking about commerce students out of the blue. That’s not even the main crux of this article, right? Let me elaborate on why. 

In the hunt for your dream home purchase, you’ve probably had terms such as interest rates and repo rates thrown at your head. Most of you know what interest rates are, but what on earth are repo rates? 

Do they matter? Does it play a significant role in my home purchase? Yes, it does. In fact, repo rates and your home loan interest rates are connected. Read the rest of the article to find out how and why. 

What is the Repo Rate?

First things first, what is the Repo Rate? The Repo Rate stands for ‘Repurchasing Option’ or ‘Repurchase Agreement’. 

The ‘Repo Rate’ is the rate at which the RBi lends money to commercial banks. When there is a shortage of funds, banks will pledge securities to the RBi and borrow funds. An interest is payable on these borrowings and the interest rate charged is nothing but the repo rate. 

The current repo rate fixed by the RBI is 6.50%, which remains unchanged as per the announcement on 8th Feb 2024. 

You may be wondering why it’s referred to as a “Repurchase Agreement”. This is because the banks will pledge a security and borrow funds. They are obligated to repurchase the particular security. 

The minimum amount that can be borrowed under Repo Rate is Rs 10 Cr and in multiples of Rs 5 Cr above the minimum amount. The duration is usually overnight or an average of 7 days. 

Let’s add some numbers to the picture so you can understand how this exactly works. Let’s assume the current repo rate is 6.50%. 

For Example: Bank A pledges a G-Sec worth Rs 10 Cr to the RBI. The RBI will now release funds worth Rs 9.35 Cr to Bank A. 

This is because Repo Rate of 6.5% will be reduced from the value of the G-Sec. The repurchase date would’ve already been fixed in advance. 

Now on the repurchase date, Bank A will repurchase the G-Sec for Rs 10 Cr. Hence, RBI earned an interest of Rs 65 Lakhs and released the G-Sec back to Bank A. 

Why is it Important?

Now you’re probably wondering why does this matter?! I’ll tell you why. The RBI uses the repo rate as a tool to control the money supply in the market. A higher repo rate means banks will hesitate to borrow funds. 

This leaves them with securities, which aren’t as liquid as cash. Thus lending of money will reduce as well. At the same time, when RBI reduces the repo rate, commercial banks will be more willing to borrow from RBI. 

This will lead to more availability of liquid cash. Thus lending will also increase and there will be more cash flows in the economy. 

Now that we’ve understood the repo rate and its importance, let’s move on to understand what home loan interest rates are and their difference. 

What is Home Loan Interest Rate?

A home loan interest rate is basically the interest that borrowers pay on the amount borrowed from a bank for their home purchase. An important thing to note is that home loans have compounded interest and not simple interest. 

This means you won’t be paying an interest just on the principal borrowed, but also on the interest that you’ve accrued. 

For a more clear understanding, let me explain the calculation of your home loan EMI with an example. The formula used to calculate your EMI is = P x R x (1+R)^N / [(1+R)^N-1]

Where, 

P = your principal amount, i.e the amount you borrowed,

R = Monthly rate of interest, basically your yearly interest divided by 12

N = Tenure of your home loan in months

For Example: Let’s assume you are taking a home loan of ₹25 Lakhs at an interest rate of 7.5% p.a for 20 years. 

In this case, the EMI would be 

₹25L x 0.625% x (1 + 0.625%) ^ 240 / [(1 + 0.625%) ^ 240 – 1] = ₹20,140

Did the math confuse you and it all went over your head? Don’t worry, just use our Home Loan EMI Calculator. Just input the amount, interest, and tenure and you’re good to go. 

But why does this calculation even matter? Basically the longer your tenure, the higher your interest payout. But at the same time, your EMI burden will drop. 

Let’s take the same example above. Over the tenure of 20 years, you’ll pay a total interest of ~₹23L. But let’s say we increase tenure to 25 years, then you’d pay a total interest of ~₹30L, but your monthly EMIs would be ₹18,475. 

Not just this, usually your EMI is split up in such a way, that you’ll mostly be repaying a huge junk of interest in the initial few years. Only in the later years will you be paying off the principal. 

Now let’s jump to the most important aspect of this article. Is the repo rate connected to your home loan interest rate? If yes, how is it connected?

The Connection Between Repo Rate and Home Loan Interest Rate

In very simple terms, your home loan EMI will be impacted by a change in the repo rate if your home loan interest rate is at a floating rate. You’ll mostly benefit from this if you’ve taken a loan from a bank. 

Banks will lend you a loan by charging a margin above the repo rate. For example: Let’s assume the current repo rate is 6.5% and the home loan interest rate offered to you is around 9.2%. 

In this case, the bank will charge you a margin of 2.70%, which is basically 6.50% + 2.70% = 9.20%. 

So in a scenario where the RBI reduces the repo rate, you will also see a drop in your home loan interest rate. Similarly, if there is an increase , your home loan interest will increase. 

Earlier I mentioned how RBI uses the Repo Rate to control the money supply in the economy. If the it is high, the bank will increase home loan interest rates, else they’ll be under loss. 

If interest rates are high home buyers would be reluctant to take a home loan. Not just this, the repo rate change affects more than just interest rates. Allow me to elaborate. 

Your EMI will increase if the repo rate increases. Similarly, EMI will reduce if vice versa. A higher EMI amount will be harder to pay off at the same time, therefore this can increase tenure as well. 

Finally, an increase in the repo rate for new borrowers can reduce their loan eligibility amount. Due to the higher interest rate, the loan amount you can borrow will reduce because your EMIs will be more expensive.

At the same time, a decrease in the repo rate can make borrowers eligible for a bigger loan amount. 

Conclusion

Repo Rates and Home Loan Interest Rates are not the same. But, the home loan interest rate is linked to the it in the case of floating-rate home loans. 

Another important thing to note is that banks offer home loans by charging a margin on the repo rate. This means your home loan rate will be directly impacted by a change in the it. 

Now, you’re well-equipped to understand what is at stake when news anchors can’t stop speaking about repo rate changes. 

An important caveat here is that this will only affect you if you have a floating home loan interest rate. But, should you opt for fixed-rate home loans instead?

In case you’re looking for advice on whether you should opt for a fixed-rate home loan or a floating-rate home loan, you can always get in touch with us at Credit Dharma, and we’ll be happy to help 🙂

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