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Do changes to benchmark interest rates impact the interest you pay for loans or the interest you get against fixed-income instruments like FDs? First things first, what is the repo rate? It is the benchmark interest rate at which the Reserve Bank of India -- the country’s central bank -- lends cash to commercial banks. You may have heard of the term borrowing costs. These are the cost of borrowing funds that commercial banks bear.

Now, changes in the repo rate -- or the key lending rate -- influence certain loans as well as deposits. Let’s take a closer look at this phenomenon.

The immediate impact of these revisions is most visible on floating-rate loans and new fixed deposits, which means that other fixed-rate loans -- or loans where the interest rate remains unchanged throughout the term – and existing FDs remain unaffected every time the RBI governor-chaired MPC changes the repo rate.

It is a crucial tool that enables the central bank to adjust the flow of money in the banking system, in turn impacting both loan EMIs and FD rates.

Most home, personal and auto loans in the country -- especially those that come with floating interest rates -- are linked to the repo rate. This mechanism is formally known as repo-linked lending rate (RLLR) or the external benchmark linked rate (EBLR).

Now, let's take a look at the potential impact of these changes.

The RBI governor-headed panel’s decision to raise the repo rate increases commercial banks’ borrowing costs. Typically, commercial banks then increase their lending rates, which means floating-rate loan customers now have to pay larger EMIs to continue servicing their loans.

The panel’s decision to cut the repo rate, as you may  have guessed, decreases the borrowing costs for commercial banks. Lenders can then reduce their loan rates, resulting in smaller EMIs for borrowers with floating-rate loans.

Let’s get to fixed deposits now -- also known as term deposits

What’s worth understanding is that changes in the repo rate don’t impact existing FDs.

Let’s say an active FD pays you 6.0 per cent interest per annum, compounded quarterly, and before the end of its term, the RBI cuts the repo rate by 50 bps. Does this mean that you get less money on the very same FD? No. However, if your bank announces a lower rate on the same FD term, and you set up a new FD after the change, you will get lesser interest proportionately.   

In other words, new FDs or renewals are influenced by the prevailing repo rate at the time of booking -- which means that the rate applicable at the time of setting up an FD is what matters and what applies for the entire maturity period of the deposit.

In a rising repo rate cycle, formally known as monetary tightening, FDs become more attractive as banks hike deposit rates, and vice versa.

Repo rate adjustments quickly impact most new loans as well as deposits. Banks adjust their interest rates in accordance with these changes from time to time, communicating changes in EMIs or FD rates to their customers. This is known as policy transmission -- which means the act of commercial banks passing on the benchmark rates to their customers.

Remember, the direct impact of hikes or cuts in the repo rate is typically seen on floating-rate loans -- auto, home or personal loans -- and new FDs, and not on already-issued fixed-rate loans or FDs.

As the interest rates for existing FDs remains locked in till maturity (which is the total period from the day of opening the account till the end of its term), nothing happens to those who already have their FDs running. However, new FDs or FD renewals  are set to reflect the latest rates.

So, all in all, in a rising repo rate cycle, FDs turn more attractive and floating-rate loans become less attractive, and vice versa.

The repo rate is the interest rate at which the RBI lends short-term funds to commercial banks, with any changes directly influencing their borrowing costs. Remember, a primary function of the central bank is to control the flow of money in the system. It is by making changes to the repo rate that the RBI eases or tightens the flow of money in the system.

Remember, inflation is the rate of increase in the prices of select goods and services. Can you guess the theoretical definition of inflation? Well, it is defined as ‘too much money chasing too few goods’.

So how we deal with a situation where too much money is changing hands in such a scenario? It is by withdrawing the available cash from the system.

This is exactly what the RBI does.

And the repo rate is the primary tool that lets it do this. There are several other tools at the RBI’s disposal.

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