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Why you will soon pay more on your home loan
Prasanna D Zore
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June 12, 2008
If you are looking out to borrow money from a bank to buy your dream house you better hurry. For there is every chance that banks will soon increase interest rates on money they lend to you and me to finance our purchases.

Just like you and I borrow money from banks to purchase homes, computers or whatever else banks also borrow money from the bank of banks, the Reserve Bank of India. Again, just like you and I pay interest on money borrowed from banks, banks also pay interest on the money they borrow from the RBI.

This interest rate that banks pay to the RBI is called as the repo rate in banking parlance.

"How does it increase my home loan rates?" I can already here some soft murmurs. Here's why.

If banks are going to pay more to the RBI then do you think they will pay it from their own pockets? No. They will -- and have always done so in the past -- pass on the increased costs to their borrowers.

This way you will soon be paying more on your loans -- home loans, personal loans, house renovation loans or whatever other creative loans your bank sells to you.

Here's what a few banks -- both private and nationalised -- were reported to have said after the RBI announcement late Wednesday. Most of them, it seems, are adopting a wait and watch policy lest they get a diktat from the finance ministry.

This is what the Business Standardreports: 'Union Bank of India Chairman & Managing Director M V Nair said that the bank may review rates next week, while Vijaya Bank [Get Quote] is due to look at the possibility of an increase later this week. Bank of India too said it will review rates but did not indicate a date.'

'Private banks are taking a wait and watch approach. ICICI Bank [Get Quote] Joint Managing Director Chanda Kochhar said the liquidity situation continues to be neutral. ICICI Bank will monitor the impact of this hike and take a decision at an appropriate time, Business Standard reported.

Housing Development Finance Corporation [Get Quote] Chairman Deepak Parekh told a television channel that the cost of borrowing will go up but a decision on interest rates was linked to liquidity conditions.

'Most of us change interest rates on the first day of the month. So, we at HDFC [Get Quote] will look at it in the month of June and it will only be effective on July 1. We have a couple of weeks to take a view, looking at what our competitors are doing, the liquidity in the market and our margins because we have to protect them. If our cost of funds goes up, we have to increase the lending rates,' he said.

Interestingly, the State Bank of India [Get Quote] (the market leader who sets the tone for an increase or decrease in interest rates especially for public sector banks), had recently increased fixed deposit rates for their customers to attract funds. Add to this the hike in repo rate -- which too will increase SBI's cost of funds which they ultimately lend to you and me. All this indicate an imminent hike in interest rates across loan products that banks hawk.

Why hike the repo rate now?

That's not too intelligent a question. Inflation has just touched a 44-week high of 8.24 per cent and has started affecting you and me through increase in prices of essential goods.

One of the reasons for the inflation number looking up, week after week, is the amount of easy and cheap money sloshing in the banking system. As interest rates are low or as money is available cheaply we demand more. Unfortunately, for various economic reasons, supply has not kept pace leading to a very high demand but weak supply (this is an over simplification, though). The basic law of economics states that higher demand in the absence of adequate supply leads to an increase in prices.

By increasing the repo rate the RBI will indirectly increase the cost of funds that you and I were so used to get at a cheaper rate. An increase in home loan (and other loans) rates is going to make us uneasy about wanton borrowing and hence leading to a fall in demand. This, the RBI believes, can help in bringing down the inflation rate. Hence the hike in repo rate.

The RBI has a host of other instruments which it uses from time to time to contain inflation. To learn more about them click here.

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