Why interest rates on loans are increased by the banks?

If you are a home buyer in the last couple of years and paying the EMI amount, you would have noticed that the interest rates gone up several times and the EMI burden would have increased. At the time of buying the house, the interest rates are cheap and bought the house with low EMI, but now the situation is different. If you are a non-financial background and don’t have knowledge on basics of finance, then you are puzzling to find the reason for the interest rates increase.

The intention of this article is to explain the readers in very simple words, the reason for the frequent interest rate hikes and what are the changes in the market impact the interest rates. After reading this article, you would have some basic idea on the interest rates.

What is Repo and Reverse-Repo Interest Rates?

Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive.  Therefore, we can say that in case,  RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system.  An increase in the reverse repo rate  means that the RBI will borrow money from the banks at a higher rate  of interest. As a result, banks would prefer to keep their money with the RBI.

How to Control Inflation?

High inflation (What is Inflation?) is the rising concern on Indian Economy. If the inflation is not controlled by the govt. it would derailed the growth of Indian economy and result in recession. In order to contain the inflation, govt. and RBI must take number of precaution measures that would reduce the inflation and save the economy from the high risk.

If you look into the main reason why inflation is high, the products in the market is on high demand because the liquidity (cash available in the market) is more. Customers can easily get the loans and purchase the goods. As we have seen in the above sections, RBI would increase the key rates to reduce the liquidity in the market. When money available in the market is reduced and cost of borrowing the money is expensive, demand will be reduced and seller forced to reduce the prices. This could reduce the inflation.

But, it will not always the correct option to handle the inflation, unfortunately RBI decided to use the rate hikes weapon several times in a year. There are no action from the govt. to prevent the inflation, rather they increase the fuel prices. It is not going to come down unless god forgives this corrupted politicians and gives good monsoon this year;).

Banks to Increase the Interest Rates

I have explained the repo rates and why RBI needs to increase the repo rates. What I have explained is the basic or most common reason why RBI raises the key rates which is resulted in increase in the personal loan interest rates. There could be several other reason to change the key rates by RBI. So, now you got some idea on the rates related to RBI and need for increase in key rates.

Once RBI has increased the rates, now banks left with the less money to lend. If the rates are the same, it could affect their margin(profitability) because the total amount they can lend to the public is reduced. The only way to bring more money into the system is increasing the deposit rates. It will stimulate the people to invest their money to deposits like fixed deposit.

Now, banks got the money from public as the fixed deposit with more interest rates, when they are lending it outside, the interest rates should be higher to get the profit. This is the very basic understand why the interest rates are increased.

Summary

I hope this article would have given the basic understanding on how the interest rates hiked by the banks. It is important to understand if you are borrower from the banks, this knowledge will help you to anticipate any future hikes and try to repay the existing loans sooner. If you have any thoughts, please post it in the comments section.

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