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Why you will soon pay more on your home loan
Prasanna D Zore
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June 25, 2008 10:44 IST

If a 50 basis point hike in repo rate was not enough to tackle inflation the Reserve Bank of India in an all-out war against inflation increased the repo rate and the cash reserve ratio each by 50 basis points on June 24. This takes the repo rate -- the rate at which RBI lends money to the banks -- to 8.5 per cent and the CRR to 8.75 per cent.

This hike comes close on heels of a 50 basis points (100 basis points = one per cent) hike in repo rate that the RBI announced on June 11. Perhaps the inflation numbers -- it touched 11.05 per cent for the week ending June 7 -- announced on Friday the 13th of June seems to have necessitated such a drastic move.

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The first victim of such a double whammy are likely to be home loan borrowers. For there is every chance that banks will soon increase interest rates on money they lend to you and me to finance our purchases. Interestingly, mots banks desisted from increasing their lending rate post June 11 hike in the repo rate.

Here's why banks will now charge more on all kinds of loans, including home loans, that you take from them.

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, RBI. 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.

Likewise, the RBI as per law stipulated under section 42 (1) of the RBI Act, 1934, states that every commercial bank has to maintain a minimum of three per cent of their net demand and time liabilities with the RBI. This is what we all call as cash reserve ratio or CRR. The RBI has increased this yet another tool to control the amount of money sloshing in the banking system by 50 basis points.

"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.

Similarly, a hike in CRR will leave less money with the banks to lend the same to their borrowers as this increase is likely to suck out Rs 19,000 crore out of the banking system in two tranches on July 5 and July 19. This is likely to reduce the supply and if demand keeps pace then as per the law of demand-supply banks will have to increase interest rates to discourage borrowers. And that's exactly what RBI would want if inflation rate has to come within the RBI's comfort levels of 5.5 per cent.

Here's what a few banks -- both private and nationalised -- were reported to have said after the RBI announcement late Tuesday. 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 Standard reports: 'Be ready for tough times and a protracted difficult period,' said a senior State Bank of India [Get Quote] executive. He said that the deposit rates will rise by 25-50 basis points while the lending rates could see an increase of 50-75 basis points.

'The sub-PLR loans will see a substantial increase when they come up for revision,' the executive added, without divulging details.

HDFC [Get Quote] Vice-Chairman and Managing Director Keki Mistry said that India's largest mortgage player will wait till Monday before taking a call on interest rates. 'I do not think that a half-a-percentage point rise will increase the cost significantly for the borrowers since the effective rate of borrowing is 5.1 per cent,' he added.

While banks had absorbed the 75 basis point increase in CRR this year and the 25 basis point rise in repo rate, the fresh moves are going to force them to review rates again since their net interest margins will be squeezed further.

'Banks, while reviewing the rates will keep in mind the unabsorbed portion of earlier measures,' Union Bank Chairman and Managing Director M V Nair said, adding that interest rates are likely to increase by around 50 basis points.

A senior finance ministry official said that the government was earlier keen that public sector banks focus on raising the interest rate on sub-PLR loans instead of effecting an across the board increase.

'Now, there is little scope for holding on to rates,' the source added. The finance ministry is expected to issue a statement early on Wednesday.

IDBI Chairman & Managing Director Yogesh Agarwal said that banks will raise deposit as well as lending rates, but he does not anticipate a drastic impact on the growth in demand for loans. 'In fact, companies will draw the sanction limits keeping in mind the trend of a rising cost of funds,' he added.

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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