BANGALORE: Over the past few years, home loan interest rates have steadily crept upwards. Everyone blamed it on inflation. In past few months, the rates have steadied after minor downwards rate revisions by the central bank. What happens during inflation?
In inflationary times, one observes a sustained increase in the average price of all goods and services produced in an economy. During this period money loses its purchasing power as each rupee buys gradually fewer goods. This situation occurs when too much money chases too few goods. This occurs when money supply in the system grows at a faster pace than output of product and services.
In an ideal scenario, inflation benefits borrowers who are repaying a fixed amount every month. Suppose a person has taken Rs 25 lakhs loan over an eight year tenure at 10 percent interest. His EMI works out to be around Rs 38,000. In an inflationary economy, over a few years, the EMI of Rs 38,000 would appear less, as the value of money falls. Further, the earning capacity of an individual increase as he climbs up the seniority ladder. However, when the rates travel upwards with inflation, the borrower feels the pinch. Inflation is hard when prices of things go up while income levels stagnate.
In order to control the spiraling inflation rate, the Reserve Bank of India (RBI) revises the key bank rates – cash reserve ratio (CRR) and the repo rate. The CRR is the funds that commercial banks are required to hold as cash with the RBI. The CRR is also called liquidity rate as it seeks to control money supply in the economy. A hike in the CRR draws out money from the banking system. This in turn checks price rise. However, as money for lending with bank dips, an increase in rates might follow.
A hike in the repo rate drains liquidity from the system and increases the cost of borrowing. The repo rate is the rate at which the RBI lends to banks. The reverse repo rate is the rate at which the RBI borrows from banks. Measures to control inflation by toggling the key rates have resulted in increase in lending rates.
Inflation is one of the main forces that increase interest rates on home loans. How can the borrowers manage their finances to combat rate hikes? Full or partial prepayment is one easy option for easing the burden of EMIs. If you have other investments that are yielding low returns, it may be wiser to use the money to repay the loan instead.