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The Making of Interest Rates

 


Prime lending Rate is the benchmark interest rate on the basis of which financial institutions decide the interest rates on the various loan products. For example, a bank might say a loan interest rate will always be 0.5% above the PLR. So this means if the PLR increases or decreases by a certain amount, the interest rates charged on the floating rate loans offered by the bank also increases or decreases by the same amount.

Shyam and his father Narendran were having a discussion on how they missed out on a golden opportunity to purchase a wonderful bungalow in Mogappair, Chennai. Six years back they rejected the location, thinking it was too out of the city to invest money and thought by the time it develops, they will not have use for it as Shyam was planning to become a green card holder eventually since he was comfortably settled into his software job in Philadelphia. Home loan interest rates were extremely affordable then.

They probably lacked the foresight that the time then was ripe for real estate investment and Chennai was developing at a rapid pace. The situation on all fronts is very different now, saturation levels have been reached in real estate with prices sky rocketing. The economic boom in India is drawing Indians from all over, back to their home country and interest rates have been increasingly making home loans dearer. However, RBI now has stepped into the scene to stabilise Indian banks in this time of a global financial crisis. In recent times CRR and repo rates have been getting cuts and in a recent move the SLR rate has also been cut. What are all these terms and how does it affect the layman who has dreams of owning a home.

All of these factors including CRR, Repo rate, Reverse Repo rate, SLR have a direct impact on the Prime Lending Rate, which correspondingly increases or decreases the interest rates of all kinds of loans, the pinch is felt by home loans in particular since they are usually borrowed in higher amounts for longer tenures. Let’s take a quick look at what all these terms mean to see how they affect our loan interest rates.

Prime lending Rate - This is the benchmark interest rate on the basis of which financial institutions decide the interest rates on the various loan products. For example, a bank might say a loan interest rate will always be 0.5% above the PLR. So this means if the PLR increases or decreases by a certain amount, the interest rates charged on the floating rate loans offered by the bank also increases or decreases by the same amount.

Cash Reserve Ratio (CRR) - It is the percentage of cash deposits that banks need to keep with the RBI on an everyday basis. Increasing the CRR also means Banks have lesser money to lend. The RBI adjusts the CRR to change the amount of liquidity in the financial system, which helps to keep the inflation within reasonable limits. Also, when CRR is increased, the interest rates also increase as the amount of liquidity in the financial system decreases. In recent times RBI has made frequent CRR cuts in the past few months to control inflation and inject liquidity in the financial system. This is expected to impact the interest rates bunched with other favourable aspects for home loan applicants.

Repo Rate - This is the interest rate at which RBI lends money to the banks whenever they need to borrow funds from the RBI. When the repo rate decreases its good news for the banks as they can avail more funds at a lower interest rate and vice versa.

Reverse Repo Rate - This means just the opposite! Here the RBI borrows funds from the banks and when the Reverse Repo Rate increases Banks are very happy to lend money to RBI because of the attractive interest rates RBI offers to obtain the loans for.

(Statutory Liquidity Ratio) SLR Rate - Every commercial bank needs to maintain a certain amount of funds in the some form, which includes cash, gold, government bonds etc. before they can provide credit to its customers. This measure helps RBI have a control over the bank’s credit expansion keeping it realistic.

The collective impact of all these rates influence the liquidity in the financial system and lead to an increase or decrease in PLR, which in turn affects loan lending rates.

 

Source: Bank Bazar

 

By vayaM CS