Bank Rate vs Repo Rate: How They Affect Loans, EMIs, and Savings
Introduction
Money is ‘as sweet as salt.’ It’s the simplest way to assert its towering importance for everyone. When we speak about money and its importance, what controls, monitors, and safeguards it are banks. Finance and the banking system are the backbone of modern civilization; hence, you must understand them thoroughly.
When dealing with, or understanding finance you will come across two of the most common terms – ‘bank rate’ and ‘repo rate.’ ‘Bank Rate’ is the rate of interest that the central bank of a nation charges on the long-term loans given to commercial banks. On the other hand, ‘Repo Rate’ is the rate of interest that a central bank charges other banks for short-term loans. Central banks use these rates to control the financial system, balancing it, ensuring its stability, and even controlling inflation.
What is a Bank Rate?
The financial system is a complex and heavy-duty mechanism. Often, banks, specifically commercial banks, need to borrow money from central banks. They charge a rate of interest on the loan amount; that interest rate is identified as the bank rate. So, the bank rate is the rate of interest that the central bank charges commercial banks for the loan that they take.
Bank Rates play crucial roles in the financial system of a nation. Changing bank rates has a direct impact on other lending rates that further influence different financial policies. So, the first and foremost role that it plays is that it controls inflation followed by stabilizing the economy. Higher availability of liquid cash leads to inflation.
Higher bank rates mean that commercial banks will increase their lending rates, too, resulting in higher interest rates for kinds of long-term loans and mortgages. As a result, borrowing money for longer duration becomes more expensive.
What is the Repo Rate?
Besides long-term loans, commercial banks also need to borrow money for shorter terms, on which central banks charge interest. The rate of interest that central banks charge commercial banks for short-term loans is referred to as the repo rate.
Since the repo rate is charged for short-term loans and has a direct impact on it, so we need to understand how it works. Interest rates, cash flow, credit history, loan terms, and financial stability are crucial factors for short-term loans. Higher repo rates will push the loan interest rates above making short-term loans costlier. While it makes borrowing difficult, it is also used as a tool for controlling inflation.
As increased repo rates spike up the interest rates and make borrowing costlier, it discourages people from taking loans. So, individuals become more cautious and check their consumption, borrowing only when it’s absolutely necessary. Thus, it checks money flow into the economy even when demand increases. As a result, people have less liquid money and thus are compelled to check their expenses. All of these add up to check inflation and control it.
Key Differences between Bank Rate and Repo Rate
There are specific points of difference between the bank rate and repo rate, and they are the requirement for collaterals, duration of the loan, their individual roles in monetary policy, their effects on commercial banks, and the frequency of their usage. So, we elaborate on these key differences one by one.
Basic understanding:
Bank rate is the rate at which central banks lend money to commercial banks without any collateral. It is a long-term loan. On the other hand, the repo rate is the rate at which commercial banks borrow money from central banks for shorter periods and by selling off government securities. However, they commit to repurchasing them later.
Requirement of collaterals
Commercial banks don’t need to furnish any collateral when borrowing money at bank rates, whereas when for borrowing money at the repo rate, they need to use government securities or other collateral. Central banks need them in case of default.
Duration of the loan
Borrowing at bank rates is usually for a longer duration; it could be for months or even years but money borrowed at repo rates is for shorter periods of time (overnight or at most, for a few days).
Roles in monetary policy
If there is an increase in the bank rate then the rate of interest on the loan amount that commercial banks have to pay central banks also increase. This flows down to long-term interest rates in the banking system or the economy; overall lending rates go high. In the case of repo rates, a change in it has an immediate effect because it applies to short-term loans. Higher repo rates lead to higher short-term loan interest; and have a direct impact on regular funds of commercial banks and their lending.
Effects on commercial bank
Higher bank rates increase the cost of long-term borrowing of commercial banks and its overall costs. As a result, to cover the increased cost, it increases its lending rates and it flows down to a higher rate of interest for consumers. While on the other hand, any change in repo rate reflects on commercial banks’ lending rates as well. Higher repo rates mean higher short-term borrowing costs for commercial banks and higher rates of credit and other short-term loans.
Frequency of their usage
Bank rates have profound implications on the economy which is why bank rates are not frequently changed. When there is a need to change long-term policies usually then bank rates are changed. In the case of repo rates, central banks use it for controlling regular liquidity and short-term inflation. So repo rates are changed often to manage inflation pressures on short-term lending and also for regular liquidity.
Functions of Bank Rate and Repo Rate
Bank rates and repo rates play crucial roles in controlling inflation and have a say in economic policies and its overall health. Let’s have a better understanding of their functions separately.
Bank rate functions:
An increase in bank rates leads to a higher cost of borrowing. Consumers cut down their spending to afford loans and pay higher interest for them. As a result, it checks consumption in the economy thereby significantly checking and limiting inflation and its growth.
Higher bank rates increase commercial banks’ borrowing costs and as a result, they increase their lending costs to bank consumers. This increases overall interest rates for loans, bonds, mortgages, and others for individuals and corporations.
Bank rates are used for balancing economies; in cases of a slow-performing economy, bank rates are lowered to allow more money to the consumers, create more economic activities and thus boost economic growth. In case of inflation, bank rates are increased to check overspending; higher borrowing interest rates will make things expensive, reduce spending, and thus control inflation to a significant extent. Thus, it plays an important role in stabilizing the economy.
Increased bank rates mean the central bank’s initiative On the other hand, lowering bank rates means its intention to boost economic activities or try to reduce the impacts of recession. or set of actions for controlling inflation.
Central banks control money supply or availability to consumers by adjusting or changing bank rates. When it wants to make less money available to the public then it increases bank rates and when it wants consumers to have enough money then it reduces the bank rates.
This is how bank rates function in an economy as its tool.
Repo rate functions:
In the banking system, when central banks want to manage short-term liquidity then they adjust repo rates. When there is an increased demand for funds, then banks reduce repo rates to ensure commercial banks have the required funds for the purpose.
Much like bank rates, repo rates too can control or check inflation. During inflation, central banks can increase their repo rates, leading to higher rates of interest for short-term
borrowing and discouraging consumers from opting for loans. Thus, it also checks their spending behavior and controls inflation.
Commercial banks can have access to immediate funds if they experience any short-term liquidity shortage. During volatile market conditions or during any financially stressed situation, central banks can increase repo rates to stabilize the situation.
Repo rates are also adjusted during high inflation or during increased demand for credits, to check such situations. Higher repo rates increase short-term loan interests and credit costs, reducing their demand and cutting down short-term loans and thus checking inflation within a short term.
Impact on the Economy
By now you must have a fair understanding of what bank rates and repo rates are and their implications for an economy. For a better understanding, let’s consider the different aspects of the economy which are inflation, growth, and lending practices.
Bank rate and repo rate impact on inflation
During inflation, the immediate need is to discourage spending, and for that central banks increase bank rates and repo rates. As a result, long-term and short-term borrowing costs increase for commercial banks and their overall costs also increase which reflects on their lending rates too. Interest rates of long-term loans, short-term loans, and credit increase which discourage consumers from taking loans and credits. It reduces their purchases and checks other consumption behavior which has a direct effect on inflation and reduces it significantly.
Read More: CERSAI: Full Form, Meaning, Function, Process and Benefits
Bank rate and repo rate impact on economic growth
Higher bank rates discourage personal investments, business expansion, and other economic activities and vice-versa. On the other hand, higher repo rates turn banks conservative on lending resulting in limited borrowing scope for businesses and individual consumers. That leads to reduced economic activity and growth and just the opposite when repo rates are lower.
Bank rate and repo rate impact on lending practices
Bank rates influence long-term lending whereas repo rates have a direct impact on short- term lending practices. When bank rates are high then borrowing becomes costlier for commercial banks which ultimately gets transferred to bank customers as higher interest rates on long-term loans like home loans, personal loans, car loans, and others. Similarly, when bank rates are low, it means lower interest on long-term loans lent by commercial banks.
As said before, repo rates influence short-term loans and credits. When repo rates are high, commercial banks have to pay higher interest for short-term funds. As a central short-term loans and credits offered by commercial banks to their customers have higher rates of interest affecting consumer interest. In the case of lower repo rates, the lending practice reverses.
If you have stayed with us throughout the blog, then you have a profound understanding of bank rate and repo rate, their difference and implications on the economy, and how they may influence borrowing rates from banks. This understanding will help you to understand future monetary policy changes, and economic activities and make better financial decisions. Above all, it will enhance your financial awareness, grow your interest in monetary policies, and even make you an active stakeholder in the process.
FAQs
Answer: The repo rate affects loan and deposit interest rates. When it rises, borrowing (like home or car loans) becomes costlier, reducing spending. When it drops, loans get cheaper, encouraging borrowing and investment. So, it directly impacts your EMI, savings returns, and overall financial decisions.
Answer: No, it’s rare. The repo rate is usually lower than the bank rate because short-term borrowing should cost less than long-term borrowing. A higher repo rate would go against standard monetary policy norms.
Answer: To manage inflation and boost growth. Higher rates curb borrowing and cool inflation, while lower rates encourage spending and investment. It’s a tool to balance economic stability and growth.
