Interest rates have been constantly in the news over last seven months. Actually, do you know how they impact economy and our personal finances? And why do interest rates change frequently? This article is a simplified guide which talks about loans and interest rates in detail and how they affect your personal finances.
Key interest rates – influential factors
Interest rate is often seen as the Cost of Money. It determines the cost of borrowing money. Money lent by banks and financial institutions for various purposes come with a cost, which is known as the loan rate or the interest rate at which the loan is lent. When interest rates are high, saving money becomes more attractive than to borrow and vice versa.
In recent times, there has been a peck of CRR (cash reserve ratio) and repo rate cuts following which interest rates on home loans and other loans have been slashed. It has been a welcome move for potential, first-time home loan borrowers who have been waiting for this to ensue since a long time.
So what do CRR, repo rate, reverse repo rate, SLR, etc mean in the context of your loan interest rate? Well, all these factors have a direct impact on the prime lending rate(PLR), which decides interest rates of loans. Let's have a glance at what all these terms mean to see how they affect the loan interest rates.
The major factor is inflation. You might have observed that whenever interest rates are discussed, inflation also comes into scene. Why? What is the relation between inflation and interest rates? Inflation is a major factor deciding interest rates.
Inflation
Interest rates are directly proportionate to the trends of inflation. To put it simply, whenever there is a rise in inflation, there will be an increase in interest rates. Inflation is an increase in the price of a set of goods and services. Inflation occurs when there is an increase in the average level of prices in goods and services. Inflation crops up when there is more demand and less supply of goods and services, which eventually results in increased prices.
Altering the interest rates is often a mechanism to influence inflation and economic growth. Excessive money in the economy results in inflationary trends. Mostly, lower interest rates will improve consumer spending and investment. This will prompt economic growth; thus, there will always be a trade off between reducing inflation and slower economic growth. Conversely, in an effort to control inflation, government may curb the money supply by rising the lending rates or PLR. Hike in lending rates impacts businesses/industries negatively which depend on banks for their working capital and expansion requirements. When RBI increases the PLR, banks may also follow the suit, making borrowing a costlier affair. Well, now the question is, "What is PLR"?
Prime Lending Rate
PLR is the rate of interest based on which the banks lend money to their credit-worthy customers. This rate is considered as the standard rate for most of the loans.
The lending rates of various banks are directly linked to their Benchmark Prime Lending Rates and are determined in terms of BPLR minus or plus x%. For example, a bank might say a loan interest rate will always be 0.5% above the PLR. This means, if the PLR increases or decreases by a certain amount, the interest rates charged on the floating rate loans offered by the bank also increase or decrease by the same amount.
The PLR is influenced by RBI’s policy rates — the repo rate and cash reserve ratio — apart from the bank’s policy. In simple words, availability of funds in the banking system and demand for credit by consumers (both retail and industrial) determine what the PLR should be.
Therefore, whenever RBI changes key interest rates, banks may alter their BPLR and thereby the lending rates. However, RBI does not set these rates, but in a broad way stipulates the interest rates in the economy. The banks are at liberty to lend at a rate above or below that of RBI. Then, what are repo and reverse repo rates and CRR?
Repo Rate
This is the rate of interest at which RBI lends money to the banks whenever they need to borrow funds from RBI. When the repo rate comes down, it's good news for the banks as they can avail more funds at a lower interest rate and vice versa.
Reverse Repo Rate
This is just the opposite of repo rate. This is the rate at which RBI borrows funds from the banks and when the Reverse Repo Rate increases banks are pleased to lend money to RBI because of the attractive interest rates RBI offers to obtain the loans.
Cash Reserve Ratio (CRR)
This is the percentage of cash deposits that banks have to maintain with RBI on an everyday basis. Increasing the CRR compels banks to have lesser money to lend. Usually, RBI adjusts the CRR to balance the amount of liquidity in the financial system, which helps continue the inflation within reasonable limits.
Besides, when CRR is increased, the interest rates also increase as the amount of liquidity in the financial system comes down. RBI has made CRR cuts frequently in the recent past to infuse liquidity into the financial system.
Statutory Liquidity Ratio (SLR) Rate
Yet, another determinant of lending rates is SLR. Every commercial bank has to keep up an assured amount of funds in some form - which includes cash, gold, government bonds, etc - before they lend money to its customers. This is the measure enforced by RBI to have control over the bank's credit expansion to keep it at realistic levels.
All these rates collectively influence the liquidity in the financial system and initiate an increase or decrease in the PLR, which sequentially affects loan lending rates. As interest rates have been slashed considerably by various banks, you have to seize the right time if you are in need of a loan.