In May 2020, banks offered loans to individuals at as low as 6%. But, if you visit the bank today, in February 2023, no one would offer a loan for less than 8.5%. What might be the reason
behind the change?
Why suddenly have loans turned costlier?
Conversely, in May 2020, FD yielded 4.25-5% returns. But in February 2023, FDs offer returns as high as 7.50%.
Again, why suddenly have FDs become lucrative?
The answer is Repo Rate. The RBI has changed the repo rate, and hence we see a change in the interest rates.
First, let’s understand the relationship between the Repo Rate, Loan Rates and Fixed Deposit Rates.
The Reserve Bank of India is the one that prints currency. Banks act as an intermediary to supply money. They accept deposits from individuals at a lower rate and give out loans at a higher rate. But what happens when the bank falls short of funds? It simply goes to the RBI and lends money at a specific interest rate called the repo rate.
RBI has other responsibilities besides printing currency and giving out loans to banks. It is responsible for keeping the economy under control and keeping track of the money supply in the economy. Hence, they have come up with an intelligent strategy.
When repo rates are low, the banks have a gala time. They take loans from the RBI and give it out to individuals. Moreover, individuals prefer taking loans because loans are available at a cheaper rate. This is precisely what happened in May 2020. The repo rate was set at 4%. So banks used to take loans at 4% and give out loans at 6%. Because of the cheap availability of loans, there was a flood of money supply in the economy, which increased the purchasing power of citizens and caused inflation.
When RBI realised that there was more money supply in the economy. It again used its intelligent strategy and increased the repo rate. So, the repo rate went from 4% to 6.50% (as of 16th February 2023). By doing so, RBI is making the availability of money harder for individuals, which will help RBI suck excess liquidity out of the economy.
In February 2023, when the repo rate is 6.50%, the bank has to pay an interest of 6.50% on the amount borrowed from the RBI. The bank has to shell out 2.5% more than it was paying earlier. Hence, it passes on the additional cost to the individuals who come to borrow money from the bank and charges a higher interest rate. Hence, we today see the loan interest rate touching new highs.
Now, what about fixed deposits?
Here, the bank has a strategy too. When the repo rate is low, the bank gives a lesser yield to FD holders. When the repo rate was 4%, your FD would earn a return of 4.5% to 5%. And the bank would give out loans at 6% to 7%.
When the repo rates increase, the availability of money for banks becomes expensive. So, to attract deposits, they offer a higher interest rate. Currently, the repo rate is 6.50%. Banks are offering fixed deposits yield of around 7.5%. And loans have become costlier to 9.5%.
The bottom line is at times of recession, interest rates tend to go down, and during inflation, the interest rates go up.
The RBI keeps an active watch on how the economy is doing and what should be done to make it stable when things go wrong. Hence, the central bank’s monetary policy objectives are the ones that influence the interest rates in our economy.