Ideally, a low repo-rate can be translated into low-cost loans for the common masses. If the RBI cuts its repo rate, it demands the banks to drop their interest rates charged on the loans. But, most of the time, this isn't the case. Under the base-rate system, RBI had set a base-rate under which the banks could not lend money. Banks will be charging the base rate plus an added interest rate, which is also known as a spread. In an ideal situation, when the RBI cuts the repo rate, the cost of fund becomes lower for the banks. Therefore, they could offer the loan at a lower rate to the customers. This could mean that the borrower will be required to pay a lower EMI since the amount of interest payable will be lower. On the other hand, when the RBI raises its repo rate, it gets more costly for banks to obtain funds, pushing them to increase their lending rates. Hence for the customers, the loan becomes more expensive as the repo rate rises and the loan gets cheaper if the repo rate drops.
The Reality of Repo Rate and EMI
The ideal relationship between EMI and repo rate doesn't play out well in reality. It has been noted that when the RBI cuts its rates, banks are very slow to decrease their rates of lending. It usually takes a long time for the banks to consolidate the changes. However, when the central bank increases the repo rate, banks are quick to raise their rates. Due to this behavior of banks, the RBI has introduced the MCLR regime which could change the way commercial banks operate linked to interest rates. Banks will be now required to publish new interest rates each month for a minimum of 5 tenures.
Furthermore, there are stricter regulations on the spread that can be applied to the base rate. Banks have a margin of 25 basis points above the MCLR, beyond which they cannot increase the interest rate. Under the new MCLR regime, the repo-rate and EMI might have a more powerful relationship than it had in the past.