This article was originally published in Postnoon on December 28, 2012. Co-author: Purvee Hetamsaria
Prof. Nicky was strolling in the park when she heard a familiar voice calling out her name. She turned around to face a gasping Mr. Mukherjee. The face had a question mark.
Prof: Hello Mr. Mukherjee. What's troubling you?
Mukherjee (trying to regain his breath): You got me! I was wondering if the Reserve Bank of India (RBI) will lower the interest rates in their upcoming policy review. The general view is that there is a strong possibility of a 75 basis points cut next year. With 50 bps being cut during the last quarter of the current fiscal year.
Prof. Nicky: Well. I cannot predict what RBI is going to do. But yes, it might be welcome by many sections of the industries and the common man.
Mukherjee: That is what I am not able to understand. How does it help the common man? Why should he worry about the matters of monetary policy? I am personally indifferent to it.
Nicky: So you feel! But it's not true. Remember the time when you took a loan to buy that car of yours and you were complaining to me about the high interest rates?
Mukherjee: Yes. But what does that have to do with RBI and rate cuts?
Nicky: How do banks determine at what rate to lend? How are auto loan, home loan, personal loan, etc, their interest rates determined? It depends on the interest rates set by the RBI. The rate at which banks can borrow funds from the RBI is known as the Repo rate. When the repo rate goes down, banks get funds at a lower rate, which they can pass on to their customers in the form of cheaper loans.
Mukherjee: Hmmm...but since I have already taken the loan, it's not going to help me.
Nicky: Its not going to help you if your loan has a fixed interest rate. If the loan has a floating interest rate, that is, it changes with the changes in the Prime Lending Rate (PLR), then your Equated Monthly Instalments (EMIs) will come down.
Nicky: It's the rate at which banks lend to their most credit worthy customers. So for most of us, after taking our credit worthiness into account, the banks decide on an x percent to be added to the PLR, to determine the interest rate. For those who have floating rate loans, the banks generally quote the interest rate as PLR plus x percent. So when PLR comes down, EMI also comes down.
Mukherjee: Got it. But what about my deposits? Will the banks continue to pay me the same interest rates on them?
Nicky: For your existing Fixed Deposits, the answer is yes. For new fixed deposits, the banks may reduce the rates.
Mukherjee: Understood. Thank you.