The Reserve Bank of India (RBI) has hiked the repo rate by 140 basis points (bps) to 5.4% so far this year, taking interest rates slightly above pre-Covid levels . The repo rate is the rate at which commercial banks borrow money from the RBI to meet their short-term fund requirements. Thus, with the increase in the cost of borrowing for banks, most banking entities have passed on close to 50 bo to 80 basis points of rate increases to customers of all product lines.
In its monetary policy statement, RBI said it decided to raise its key interest rates to contain inflationary pressures and maintain macroeconomic stability. The rate hike was in line with continued growth momentum in FY23 at 7.2% and did not lead to a significant slowdown in investment demand or job creation. This is despite forecasts that inflation is likely to remain above the upper 6% tolerance range for much of this year.
How banks reacted to repo rate hikes
The Covid-19 pandemic has lowered the demand for home loans as people focus more on their basic needs and have less disposable income to cover their monthly equivalent payments (EMI). Those who already had outstanding loans were given a moratorium to ease the pressure. But as the economy recovered from the peak of the pandemic, a low interest rate regime boosted housing affordability and revived demand for home loans.
But since May, most lending institutions have rapidly increased their marginal cost of funds-based lending rate (MCLR) to compensate for their lost revenue. Housing finance companies (HFCs) have raised their prime rate (PLR). The net effect for the borrower is higher rates and the need to prepare for further hikes in the coming months given the rising trajectory of global interest rates and inflation high due to geopolitical tensions.
Accordingly, all lenders, including home loan providers who borrow funds from the central bank or other banks or regularly borrow from the debt market in the case of NBFCs/HFCs, should raise their interest rates. loan depending on the upward movement of costs.
Rates 100 to 150 basis points higher are unlikely to have a negative impact on homebuyer sentiment, especially in the small ticket segment.
A rise in rates beyond 150 basis points will likely lead to weaker demand from new borrowers. That said, it remains to be seen how the homebuyer’s outlook has evolved during the pandemic. Most of us know that consumer preferences have shifted dramatically across industries due to COVID-19, and a similar trend has also been seen in real estate.
Home ownership is high on the priority list of Indians, and housing demand has shifted from compact homes in metropolitan areas to larger homes in the outskirts. Thus, despite higher interest rates, demand for housing from small owners should remain robust.
How Consumers Responded to Repo Rate Hikes
There is no standard impact on borrowers in the real estate sector, as the influencing factors of a rise in interest rates differ between categories.
Although small borrowers are less affected by rate hikes, it could cause problems for those who have taken out large loans and opted for floating interest rates on their loans. There is undoubtedly a specific reason for the immediate impact on borrowers with a floating rate, as it is mandated to be tied to a benchmark such as the repo rate. And the subsequent effect on the repo-linked lending rate (RLLR), such as the floating rate, is seen in a quarter of the change in the benchmark.
Investment home buyers tend to opt for higher loan amounts than independent home buyers and affordable home buyers. Indeed, they plan to use these properties as an investment vehicle or even to rent them out if there is no possibility of selling them at higher prices in the future.
Since investment home buyers have a larger loan amount, they are naturally more affected by rate increases in a variable interest option. As a result, they will have to pay more on the interest component of their loans as lenders raise interest rates triggered by rising RBI repo rates.
As is clear from the explanation of rate differentials, the buyer of an independent affordable home with a lower loan amount is less likely to be affected by rising rates.
What should consumers do when taking out a home loan?
Fixed rate home loans
Borrowers of fixed-rate mortgages are unaffected by interest rate increases because current interest rates are locked in for part or all of the term of their loans. Therefore, if you have taken out a fixed rate loan, there will be no impact on your monthly EMIs or repayment amount at this time.
Borrowing rates have increased, as have deposit rates. So the smart ones who opted for a fixed interest rate option for more certainty have managed to avoid the risk now. They can try to save and take better advantage of these savings to deal with continued inflationary pressure.
Affordable Home Loans
However, there are two notions in the context of the rates chosen by buyers of affordable homes.
Some small borrowers with low disposable income and less aware of financial markets tend to jump at the low interest rate opportunity. These borrowers benefit in the short term from the low interest rate of a floating option. But the rate hike by RBI, as seen recently, has a direct and negative impact on their financial stability as they pay much more interest after the move.
This is a result of lenders reacting quickly to rising repo rates by increasing their MCLR/PLR.
Borrowers who have a better understanding of how markets work and who have the convenience of income tend to opt for fixed rather than floating rate loans. This is even if the fixed option interest rates are higher than the contemporaneous floating rate in a low interest rate regime.
The logic stems from their low appetite for risk coupled with fluctuating interest rates over periods ranging from one to five years, depending on the individual needs and financial situation of the applicants. Rates may vary depending on prevailing market conditions when taking out mortgages on their properties. But fixed interest rates are still safe, and borrowers can effectively budget their future payments accordingly.
Variable rate mortgages
The disadvantage of a variable rate option is that it makes loans unnecessarily large at a later stage when the borrower is paying much more interest than the principal repayment. Assuming that most variable rate borrowers are the most vulnerable section of society, we can conclude that they are in a position where they cannot bear the brunt of rising rates.
According to RBI data, home loans account for around 65% of all outstanding bank loans in the country. Most of these borrowers opt for variable rate loans which are affected by interest rate increases. Regardless of which category a borrower falls into, the ideal approach to avoiding defaults is to budget for expenses well in advance. Planning involves things like:
- Check interest rate options;
- Optimize other spending to accommodate uncertainties (such as rate hikes);
- Ensure a safety net (such as an emergency fund with disciplined savings in a safe lane); and
- On top of everything, repay loans as soon as possible by staying ahead of schedule.
The era of low interest rates seems to be over and better financial planning for its future will ensure that it has a limited impact on rising interest rates. The silver lining is that you will possess an asset that will also appreciate.