When the funds are short, most individuals turn to short or long-term loans to cover their expenses. Whether to purchase a home or car or finance a child's education or wedding loans are excellent funding options to divide the total cost into manageable EMIs. While considering borrowing a loan, understanding the repo rate and reverse repo rate meaning is crucial, as they will largely affect the borrowing cost.
Repo and reverse repo rates are crucial for the RBI to inject cash into the economy and maintain liquidity. While the RBI frequently revises these rates, their impact extends to investments, loans, and yields. Although their purpose is the same, there are significant differences one must know to ensure financial stability. So, here is a breakdown of what the reverse repo rate is and other crucial details to learn.
What is the Repo Rate?
The interest rate at which the Reserve Bank of India (RBI) lends loans to commercial banks is called the repo rate. Commercial banks obtain loans from the RBI against treasury bills and other government securities. Repo stands for Repurchasing Option. It is an agreement between the bank and the RBI to repurchase the securities at a particular price on a specified date. The RBI uses the repo rate to control the country's inflation rate. A higher repo rate means more expensive loans for consumers, reducing cash flow in the economy.
What is the Reverse Repo Rate?
The reverse repo rate is the interest rate at which the RBI borrows money from a commercial bank. It is an instrument that the central bank uses to control the money supply within the economy. The money supply will decrease if the rate increases, and vice versa. A higher reverse repo means a commercial bank will earn more by depositing its excess funds with the RBI, decreasing the money supply in the market. The RBI uses this rate to maintain a steady source of liquidity when the need arises. Commercial banks also benefit by depositing money with the central bank, as it is a safer place to park funds and earn interest.
Impact of Reverse Rate on Indian Economy
The reverse repo rate significantly impacts the economy. Commercial banks deposit excess funds with the RBI to earn interest when it increases. Banks will find it more beneficial to deposit money with the central bank rather than lending it to businesses and individuals. As a result, the supply of money decreases in the economy, and the value of the rupee gets a boost.
The RBI controls inflation by increasing the rate and cutting it back to inject liquidity when the conditions are favourable for rising inflation. The impact of the rate change is also evident in consumer durable loans, as a higher reverse repo rate encourages commercial banks to invest excess funds into low-risk securities rather than lending them to consumers. Consequently, loans become costlier. The effects are the opposite when the RBI decreases the rate.
Difference Between Reverse Repo Rate and Repo Rate
After understanding what they are, we will now examine the difference between repo rate and reverse repo rate:
| Parameter | Repo Rate | Reverse Repo Rate |
| Lender and Borrower | The lender is the RBI, and a commercial bank is the borrower. | The lender is a commercial bank, and the RBI is the borrower. |
| Objective | Commercial banks borrow loans from the RBI at a repo rate to manage their short-term deficiency of funds. | The RBI borrows loans from commercial banks to reduce cash flow in the economy. |
| Interest Rate | The repo rate is higher than the reverse repo rate. | The reverse repo rate is lower than the repo rate. |
| Type of Agreement | A repurchase agreement is required to determine the applicable repo rate. | A repurchase agreement is required to determine the reverse repo. |
| Source of Funding | For the repo rate, the operational system for commercial banks receives funds from the RBI by pledging government bonds as collateral. | In a reverse repo, a commercial bank deposits excess funds with the RBI and earns interest. |
| Impact on the Economy | When the repo rate increases, the cost of funds increases for commercial banks, making loans more expensive. | Commercial banks deposit more money with the RBI when this rate is high. As a result, the cash flow in the economy becomes lower. |
| Impact on Loans | A reduced repo rate means cheaper loans for commercial banks, leading to lower interest rates on consumer loans. | A lower rate means reduced RBI deposits and more banks lending loans to consumers, increasing the cash flow in the economy. |
How to Calculate Reverse Repo Rate?
The Reserve Bank of India determines the reverse repo rate based on the prevailing economic situation, including recession and inflation. The Monetary Policy Committee is a committee working under the RBI governor responsible for calculating and setting the reverse repo rate in India.
For instance, if the market has excess liquidity, the RBI withdraws money from the system by increasing the reverse repo. It makes RBI deposits more beneficial for commercial banks than lending to consumers. As a result, banks lend fewer loans or increase their interest rates on consumer loans, reducing liquidity in the economy. The RBI calculates the rate based on several economic and financial factors. For instance, today's reverse repo rate, as of August 2023, is 3.35%.
How Does Reverse Repo Rate Affect Personal Loan Interest Rate?
Every time the central bank changes the reverse repo rate, the cost of consumer borrowing increases or decreases. Commercial banks prefer depositing their money with the RBI when the rate rises rather than lending to consumers. As a result, they increase their interest rate to discourage borrowing or earn a similar interest rate from borrowers.
Similarly, banks prefer lending over depositing with the RBI when the rate decreases. For that purpose, they reduce their interest rates to encourage consumer borrowing. So, while looking for a Personal Loan, one must time an application for a loan when the reverse repo rate is low.
Conclusion
While planning for an application for a loan, one must check the prevailing repo rate and reverse repo rate in the economy to make an informed decision. After understanding the reverse repo rate meaning, it’s clear that it can significantly impact Personal Loan interest rates. Therefore, comparing the rates and timing the application well is crucial. At Hero FinCorp, one may find the most competitive interest rates under different market and economic conditions.
Frequently Asked Questions
1. What is the reverse repo rate?
The reverse repo rate is the rate at which commercial banks deposit excess funds with the central bank. It is a safe strategy to secure funds when they are surplus. Simply put, it is the rate at which a commercial bank deposits cash with the Reserve Bank of India.
2. What is the difference between repo rate and reverse repo rate?
The primary difference between repo and reverse repo rates is that the repo rate brings income to commercial banks through lending. In contrast, reverse repo brings income through funds deposited with the RBI.
3. What is the reverse repo rate, with example?
The reverse repo rate is the interest rate a commercial bank earns by depositing its excess funds with the RBI. For instance, if a commercial bank deposits Rs 1 Lakh with the central bank at 5% p.a., they will earn Rs 5,000 p.a. as interest.
4. Why RBI uses a reverse repo rate?
The Reserve Bank of India uses reverse repo rates to manage short-term liquidity in the economy and control the cost of consumer loans.
5. What is SLR and CRR?
SLR, or Statutory Liquidity Ratio, is a mandatory reserve a commercial bank must maintain. CRR, or Cash Reserve Ratio, is the percentage of the bank's deposit a bank holds with the central bank in cash form.
