RBI policy review: Here's how 0.25% rate cut will affect you

When interest rate is low, banks' lend at a cheaper rate, leading to a fall in EMI, boosting industry, economy

The Reserve Bank of India Tuesday cut its key interest rate by 0.25% in its first monetary policy review for financial year 2016-17. The repo rate, the rate at which RBI lends money to commercial banks, now stands at 6.5%.

This implies a reduction in the rate helps banks borrow money at a cheaper rate and vice versa. Whenever banks have any shortage of funds, they can borrow from the RBI.

Similarly, the reverse repo rate which stands at 6% is the rate at which RBI borrows from banks.

Therefore, when the interest rate is low, lending by banking system becomes a bit cheaper, leading to a fall in EMI, thereby providing a boost to industry and economy in overall.

The twin rates are also a key weapon for the RBI to keep a rein on inflation. Raising the repo rate in a high inflation scenario helps RBI to disincentivise banks to borrow money. This reduces money supply in the economy and helps in keeping inflation under control.

Similarly, RBI takes the contrary position when inflation moves southward.

Now, a reduction in the key interest rate or repo rate will have the following effects:

Effect on consumers: Naturally, a fall in the interest rate prompts one to save less and spend more. Due to low interest rate, loans, particularly home loans will see a rise and this benefits the real estate market.

There are two types of home loans: floating rate loans and fixed rate loans. The interest rate on floating rate loans keeps fluctuating as banks take their cues from the central bank’s policy rates and a subsequent revision in it, whereas, interest rate on fixed rate loans do not get affected by market fluctuations.

Now that banks have started reducing the interest rates, it may be time to weigh your options between going for a floating or a fixed rate home loan product, depending on how far you see the lower interest rate cycle to last.

Either ways, fixed interest rates are much higher than a floating rate and one should research well before getting locked in a fixed rate. Also read the fine print well as most banks have 5-year reset clauses.  

But lower interest rates also mean that you lose out on a higher return on your fixed deposits as banks reduce rates proportionately to protect their margins. Pensioners who depend on bank deposits are the worst affected in a low interest rate cycle.

Similarly, cheaper car loans and student loans will also push demand in these segments.

Start-ups can also avail loans at a lesser rate as banks and other lending institutions compete with each other to offer loans at the most favourable rates.

Price of commodities: It is not necessary that prices of commodities have to come down when interest rates go down. But if it does, it is beneficial to invest in say gold or appreciating assets such as real estate and book profits when they rebound, rather than spending on consumables.

Job market: When capital becomes cheaper, companies tend to expand their operations, thus, generating employment as they would need more manpower. This, coupled with government reforms will increase industrial output, and hence Gross Domestic Product.

Equity Markets: The positive impact on consumption along with lower interest outgo would also mean high profits and thus better valuations for the equity market. Further, lower interest rates means that money will move from lower yielding debt instruments to the risky, but high return yielding equity market.

In conclusion, it is unwise to park your money with the bank when interest rates come down. This is because earnings on your fixed deposits will be negligible at a time when economic activity is high because banks do not want to take the risk of raising high-cost funds at a time when borrowing rates are falling.

Rather, it is advisable to liquidate short­ term fixed deposits and invest in less risky mutual funds or government infrastructure bonds, keeping your long term fixed deposits safe.