On Wednesday, the Monetary Policy Committee of the Reserve Bank of India (RBI) decided to cut the repo rate by 35 basis points (bps). This event sparked various reactions from the financial markets as with the recent cut; the repo rate now stands at a nine-year low. The 35 bps decrease came as a surprise owing to the previous repo rate cuts in 2019, which have been restricted to 25 bps.

From 6.50% to 6.25% in February; 6.25% to 6% in April; and 6% to 5.75% in June. At present, the repo rate stands at 5.4%.

What is a Repo Rate?

Simply put, Repo Rate is the rate at which the RBI lends money to commercial banks. Reduction in repo rate helps the commercial banks to get money at a cheaper rate and increase in repo rate discourages the commercial banks to get money as the rate increases and becomes expensive.

Repo rate and home loan

The Marginal Cost of Funds based Lending Rates (MCLR) system was introduced in April 2016 to tackle the problems of the Base Rate regime. The base rate did not allow consumers to benefit from the RBI rate cuts. This was the primary reason to switch from base rate to MCLR. The MCLR, on the contrary, takes into account the rate at which the bank raises deposits, and other costs of borrowings.

Following RBIs decision, the State Bank of India (SBI) announced a reduction in its MCLR or marginal cost of fund-based lending rate, by 15 basis points across all tenors. The revised rates will be effective from 10 August 2019. After the latest cut, SBI said home loans linked to MCLR rates are now cheaper by 35 bps since April 10, 2019.

Other banks are also likely to review their lending rates soon.

In addition to the home loans linked to the bank's base rate and MCLR, the borrowers have an option to choose home loans based on the repo linked lending rate (RLLR). From July 2019, SBI had started offering a repo rate-linked home loan product. The interest rate on this new home loan product gets revised whenever there is a change in repo rate.

Proper transmission of repo rates by the banks to the borrower remained a major concern. It was found that the banks were hesitant to pass on the benefit when RBI cut the repo rate but were eager to raise the rates when the repo rate inched upwards. To address this issue, RBI asked the banks to link home loan rates to an external benchmark rather than linking them to the MCLR, the bank's internal benchmark

With the recent cut in RBI's repo rate, SBIs effective Repo Linked Lending Rate (RLLR) for cash credit/overdraft customers will stand revised to 7.65%.

Why is there a minimal change for the consumer?

The transmission of an interest rate cut or increase is not a hundred percent. Thereby, even though the RBI has cut the repo rate by 35 bps, consumers will receive a much lower reduction in the interest rate on their borrowings. This is due to many factors, including the health of the concerned commercial bank.

Over the past few years, banks have seen a drop in their profits plummet because many loans have turned out to be non-performing assets. To cover for these losses, the banks have to use their existing funds, which would have otherwise gone to common consumers for fresh loans.

The reduced repo rate applies only to new borrowings of banks. The banks' cost of existing funds is higher.