Repo Rate, Reverse Repo Rate and Bank Rate

On May 3rd 2011,  the Reserve Bank Of India (RBI) increased key policy rates i.e., repo rate reverse repo rate and bank rate to contain inflation. While this was in the news big time, not many of us would have realized its direct effect on our everyday lives and our financial planning.

Here are some key definitions and explanations of repo rate reverse repo rate and bank rate –

 understanding them would help you figure out how the RBI interest rate hikes  in 2011 effects you financially.

What is bank rate ?

Bank rate is the rate at which any central bank (RBI in our case) lends to banks. If the bank rate moves up, the long term interest rates also move up. Similarly, if it moves down, the interest rates move down as well.

So, it is safe to conclude that the bank rate is RBI’s outlook on interest rates.

How does this effect investors ?

We borrow money from banks to buy cars and houses. Banks borrow money from each other and from RBI and lend to us. To make a profit, they borrow on a less rate and lend us money at a high rate. The differential is their profit.

So if the RBI were to hike the bank rate, banks  will have to pay more for borrowing money. The banks will in turn pass on the higher rate of interest to you and me, resulting in higher interest rates for the loans we have taken.

• The bank rate currently is 6% and it was not increased on May 3rd 2011 hike.

What is Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow money from the RBI. Banks also need to borrow money because of the huge demand they are facing from investors who want loans.

If the RBI wants to make it cheaper for banks to borrow money, it reduces this rate. Similarly, if RBI wants to make it expensive for banks to borrow money, it increases the rate.

How does this effect investors ?

If you ask for a loan from the bank and the bank does not have money, it will borrow money from RBI and give you the loan. However, it will also pass on the increased rate of  interest to you so that you have to cough up the increased cost of its borrowing.

• The repo rate currently is 7.25% and it was increased on May 3rd 2011 by 50 bps

Simply put, the investor ends up paying a higher rate of interest on loans he is servicing. This means an increased EMI (Equated Monthly installment) each month. A higher EMI leaves less money for saving and investing for your financial goals.

A lot of investors also do not borrow at all and put aside their decision of buying cars and houses for a future date. This is exactly what RBI wants as well – less money to enter the financial system.

The is RBI’s way to tame inflation – by cutting the amount of money that enters the economic system. What’s the connection here ?

When economic growth of a country is healthy, investment activity is very high. This leads to demand for money. If demand for money is allowed to continue, it can lead to rise in inflation. RBI steps in to control the demand of money by controlling interest rates. It increases the interest rates so that people borrow less.

What is Reverse Repo Rate

This is opposite of repo rate. It is the rate at which banks lend money to RBI. Or to put it the other way around, this is the rate at which RBI borrows money from the banks.

Yes, even the RBI borrows money.

This is another method used by the RBI to control spiralling inflation. When the RBI thinks too much money is floating in the economic system, it increases the reverse repo rate. This means that suddenly, the banks have a place to park their money which will fetch them a better rate of interest. Their money with RBI is completely safe. It is risk free. Obviously the banks will not want to lend out money to you and me instead.

How does repo rate reverse repo rate and bank rate effect investors ?

If this rate is increased, the banks will want to park their money with RBI and not lend to investors. They will lend to you if you are ready to pay a higher rate of interest. So this will also translate into a higher cost of borrowing for the investors.

• The repo rate currently is 6.25% and it was increased on May 3rd 2011 by 50 bps

If you note, increase in both the rates will result in an increase in borrowing costs for the investor. In such scenarios, investors are left with less money to save for their future. Those that have a floating rate of interest, see their EMIs rising even more.

Another thing to note is that

• the repo rate was 5% in March 2010 and is now (May 2011) 7.25%
• the reverse repo rate was 3.5% in March 2010 and is now (May 2011) 6.25%

Now in just one year, that is a huge increase in both the rates.

To take an example, look at what an increase in 1% interest rate would do to your loan. It will increase your EMI by Rs 1,190 and the overall extra interest that you pay out will be more than two lakh rupees.

Having gone though the current rates which were published on May 3rd by RBI, you will note that RBI is lending money to banks at 7.25% (repo rate) and borrowing money from banks at 6.25% (reverse repo rate). That is a difference of 1% which is RBI’s profit. RBI is like any other bank wanting to make a profit.

Let’s hope that the steps RBI has taken has the desirable effect – to control inflation. That is a bigger challenge for RBI at the moment.