06 Nov 2015

Pratik Bhartia

Understanding Macro Economic Interest Rates and its Impact on personal finance

Recently RBI announced a rate cut and there were a lot of terms that were being

discussed like Repo rate, Reverse repo rate, CRR, base rate etc. These rates

impact the overall economy of the country and have a bearing on your personal

finance. Let us understand what each of these terms mean and the effect they

have:

Repo rate is the rate at which RBI lends money to the banks. Bank use these

funds to meet the gap between the demand (loan requirement by various

customers) and the money they have at hand to lend (deposits from customers).

Lowering of the repo rate means that its less expensive for banks to borrow

money, which it can lend out as loans. This in effect, translates into lower rate of

interest that the bank in turn charges its customers. Simply put, when the repo

rate is reduced, you can expect the interest rate on your existing loan/fresh loan

to go down.

As the name suggests, Reverse repo rate is exactly the opposite of Repo rate. It’s

the interest which RBI pays the banks when they park their surplus money with

RBI. It’s a tool which is used by the central bank to reduce the amount of money

floating in the economy. Higher reverse repo rate means the banks will be more

inclined to put the money with RBI (virtually risk free) rather than lending it in

the open market.

CRR or the cash reserve ratio signifies the portion of deposits that a bank has to

mandatorily keep parked with the RBI. CRR serves twin puropse. It ensures that

some portion of the bank’s cash is always risk free. It serves as a tool for RBI to

control liquidity in the economy. Higher CRR will mean the banks will have less

funds to lend in the market.

Base Rate is probably the most important rate when it comes down to an

individual borrower. It signifies the minimum rate at which the particular bank

will lend to its customers and its prominently displayed on the bank’s website.

The banks are free to set their own base rate and its typically derived by the

banks using a complex formulae of Repo rate, operating costs and profit margins

they intend to make. The loans given out to the customers is a sum of the base

rate and the interest spread/premium that the banks wants to charge based on

the risk profile of the borrower.

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