All About Switching To A Repo Linked Home Loan

Repo and Reverse Repo

Commercial banks borrow from the Reserve Bank of India at the Repo rate; RBI borrows from commercial banks at the Reverse repo rate. A repurchase agreement or repurchase option or repo, for short, refers to an arrangement where banks provide such securities as treasury bills or gold to borrow money from the central bank for overnight credit when the banks are short of liquidity. 

The money that commercial banks borrow from the central bank is meant to extend loans to their customers. Typically, customer deposits are also used to meet a bank’s liquidity needs. Banks borrow from the RBI at the prevailing repo rate when that is insufficient. 

Securing credit for banks is not the only function of the repurchase agreements or repos. Say, during inflation, the banking regulator or the RBI increases the repo rate. This signals to commercial banks that the RBI discourages borrowing for credit creation, which increases the supply of money or liquidity in the economy (a cause for further price rise). In the case of inflation indicators falling below a threshold, the reverse technique of reducing repo rates to encourage borrowing by commercial banks is followed. This would cause increased credit creation, which would increase the money supply and investment activity in the economy. The credit received by banks from RBI is only for an overnight duration. The securities deposited by the banks are released at a predetermined price on payback of the borrowings by the banks.

Similar liquidity needs of the RBI and their fulfilment by the commercial banks are done at the prevailing reverse repo rate. The RBI uses the reverse repo rate as an alternative method to maintain the determined inflation levels. The RBI does this by absorbing the money supply from the market at the reverse repo rate. When the reverse repo rate increases, it signals to the banks that the banking regulator wants them to lend money to the RBI, thus sucking up the credit and the liquidity in the market. The opposite happens when the RBI reduces the reverse repo rate. It signals to commercial banks that credit creation and investment activities are encouraged.

Repo-linked home loans

The concept behind repo-linked home loans is that banks and financial institutions pass on the changes in the repo rate to the borrowers. As the bank’s borrowing cost goes down, home loans become cheaper or vice versa. For instance, during the pandemic, the RBI had brought down the repo rate to 4%, and the banks, on their part, also lowered their lending rate. Banks are quicker in passing on repo rate-related hikes in home loan interest rates to borrowers than a drop in repo rates, which causes their lending rates to drop.

Earlier, banks charged the PLR, Prime Lending Rate, but the RBI felt it wasn’t transparent enough and introduced the Base Rate concept. The Base Rate specifies a minimum rate below which the regulator forbids the banks from lending, even to their preferred clients. This provided the transparency the RBI wanted to see. It also ensured that any reduction in the repo rate would be passed on to the customers.

Evaluating Repo-linked Home Loans

Whether one is switching to a repo-linked rate or taking a new home loan, the following observations might be helpful:

• Movements in the repo rate get factored into the EMI quicker than any rate benchmarked against banks’ internal cost of funds.
• There is greater transparency in the rate-setting process
• EMIs can increase if the repo rate increases.
• Eventually, the lender or the bank settles on the final rate. The repo rate might be 4%, but the market rate for a home loan is 7%. It can fall or rise a few points based on the movement of the repo rate.
• RBI wants all banks to adopt the linking of new loans to the repo rate, which is an external benchmark for greater transparency. The State Bank of India (SBI) has already adopted the repo-linked lending rate (RLLR) for its home loan, and so have the Bank of Baroda (BoB) and Syndicate Bank. The others are considering the switch.
• RLLR will bring a change in the banks’ reluctance to reduce rates. According to some estimates, RLLR rates are 25-45 basis points cheaper than MCLR-linked rates (Margin Cost of Funds Lending Rate).

Switching to a Repo-linked loan

Switching to a repo-linked loan is about scrutinizing the costs involved:

• Switching to RLLR within a bank is a straightforward proposition: the conversion fee paid by a borrower upfront versus the savings on interest is to be watched.
• Switching to another institution typically happens when a borrower is unhappy with the existing institution’s rates, processing charges, valuation charges, or legal fees. More significantly, studying the spread that the other bank is charging over and above the RRLLR will be important in making the decision. Choose the bank which has the narrowest spread. That spread will mirror the RBI’s recommended rates more closely – the higher the loan’s value, the closer the fit.

To summarize

A word of caution. Let’s assume that the discussions have started with a bank, and the borrower feels that the initial rate looks attractively low. However, the factors that increase the interest rate, namely the loan-to-value ratio, the borrower’s credit score, and the number of other house properties the borrowers own (two or more), could quickly increase the rate. It is therefore suggested that the difference between the bank’s RLLR and the net interest rate should be watched carefully before deciding on the switch. If you are short of funds, avail of a Home Loan from Tata Capital.