Tuesday morning 11 a.m. Ram was sipping his coffee inside a cabin at his office. News channels were screaming with the breaking news - RBI cuts repo rate by 25 basis points (0.25%). Quite excited, Ram jumped in joy, spilling coffee across his desk. Puzzled by his excitement, his manager, Shyam, asked why he was on cloud nine.
Ram said, “Sir, RBI has cut the repo rate, so my EMI will come down for sure.”
“Oh! Ram, things don’t work that way. It’s not a hard-and-fast rule that your EMI will automatically be slashed whenever the RBI cuts the repo rates. Lots of factors are considered before your EMIs are reduced in real time.”
Ram looked upset, confused too. “But sir, every time RBI reduces the repo rate, the news channels flash breaking headlines that home loans, car loans will get cheaper. That’s the ideal goal of the repo rate cut, right?
Sensing Ram’s genuine confusion, Shyam smiled, pulled up a chair and leaned in. He was determined to set the record straight and dispel Ram’s doubts.
“Look Ram, as I said earlier, there are several factors involved in this game. First, who is your lender really matters. Compared to Housing Finance Corporations (HFCs), banks pass on the RBI’s rate cuts benefits to their customers much faster. It’s because banks are strictly bound by external benchmarks such as repo rates, thereby making the transmission transparent and faster. In contrast, HFCs rely on their own internal benchmarks — so, even when RBI cuts repo rates, HFC customers are forced to wait for months or sometimes, they might not benefit from the cut at all.”
“Also Ram, the type of interest rate you’ve opted for while taking a loan also matters a lot.”
“You mean sir, whether I have chosen fixed interest rate loan or floating interest rate loan,” Ram asks.
“Yes Ram. But that’s not just about fixed vs floating interest rate. If your loan is linked to the repo rate or another external benchmark, RBI rate changes reflect faster in your EMI. On the other hand, if your loan is tied to the Marginal Cost of Funds-based Lending Rate (MCLR) or the base rate, the transmission is much slower. These are older systems that revise rates only periodically, so you don’t immediately feel the impact of RBI cuts.”
Ram asks, “Sir, then fixed or floating interest rate doesn’t really matter?”
“It indeed matters Ram. Fixed loans give you stability, but will not benefit if RBI cuts rates. Whereas with floating loans, you can save some money when rates fall. However, the real difference lies in the benchmark of your loan — repo-linked loans reflect RBI’s changes quickly, while MCLR or base rate loans take time.”
Ram is in deep thoughts for a while as asks, “So, sir, if I want my EMI to reduce quickly whenever RBI cuts rates, I should opt a repo-linked floating loan, right?”
Shyam nods, “Exactly, Ram. But remember, the same logic applies when rates rise — your EMI will also increase faster. Therefore, choosing the right type of loan depends on your risk appetite and how much stability or flexibility you prefer.
Shyam then adds, “Ram, you should also consider the reset period of your loan. Even in floating loans, banks don’t revise EMIs EMIs immediately. Some banks revise it once in three months, some do it every six months. Therefore, even if RBI cuts rates today, your EMI will reduce only after your reset period.”
Ram asks thoughtfully, “Sir, so before taking the loan, we must ask the bank about the reset frequency. “A shorter reset period means you benefit faster when rates fall, but also face faster increases when rates rise. Is that right?
Shyam nods, “Exactly, Ram.”
Ram, eyes widening with curiosity, asks, “Sir, if RBI cuts repo by 250 basis points, will my loan rate also drop by 250 points? First tell me how to convert basis points in percentage?”
Shyam chuckles, “Not fully, Ram. There’s something called partial transmission. For instance, out of 250 basis points cut, borrowers might get only about 150 basis points relief. The reason being banks’ funding costs are not always tied to a repo; they also rely on deposits and bonds. And about basis points, it is nothing but a way to measure small changes in interest rates. One basis point is one-hundredth of a per cent, that is, 0.01%. In short, 100 basis points is equal to 1%. Therefore, when we say 250 basis points, it simply means 2.5%.”
Ram frowns, “Sir, so banks don’t pass the entire benefit to us?”
Shyam smiles, “Spot on, Ram. Apart from the repo, every loan has a spread, which covers the operating costs, risk premium and profit margin of the banks. Banks can adjust this spread, especially for new borrowers. So, while repo cuts help, the final benefit to you depends on both the repo and the spread.”
Ram says, “OMG! It’s too complicated, sir.”
“No Ram, let me explain. Your home loan interest rate is made of two parts: the repo rate and the bank’s spread. If the repo rate is set by RBI, any cut ideally reduces your loan rate. The spread is added by the bank to cover its operations costs, risk and profit margin.”
“For example, say, in your loan, the Repo Rate = 6.5%, spread = 2% and the home loan rate = 8.5%. If RBI cuts the repo to 6.25%, in theory your home loan rate should come down to 8.25%. Instead, banks can keep the spread the same or tweak it for new borrowers. This means, your actual EMI reduction might be smaller than you expected. So, even with repo cuts, EMI doesn’t always drop fully because the bank’s spread remains a fixed or semi-fixed component.”
Ram nods slowly, asking, “Sir, does it also matter whether I am an old borrower or a new borrower?”
Shyam replies, “Of course, Ram. Often, banks cut the rates to attract new borrowers. New borrowers might get repo-linked rates or promotional discounts. But older borrowers, especially those who have the MCLR or BPLR rates, continue to pay higher rates. For existing borrowers, EMIs won’t automatically drop unless you request for a conversion to a repo-linked loan. At times, there might be a small conversion fee, but it’s usually worth it to benefit from the latest repo rate cuts.”
“So, it’s not just the repo cut, my lender, loan type and the spread all decide my EMI,” Ram murmured to himself.
Shyam nodded. “Exactly, Ram. And this is just the beginning. There are other factors too. We’ll dive into them later. For now, focus on clearing your pending report by 5 p.m. Let’s catch up after that.”
Cheers! Catch you later with the second part of this informative home-loan episode. Until then...