Would Interest Rates Decline If Raghuram Rajan Cuts The Repo Rate?

Most people apply for a mortgage loan while buying a home because it is often the single biggest financial transaction in their lives. In India, even up to 80 per cent of the value of the home could be funded by the mortgage loan. So, the interest paid on the mortgage loan forms a major fraction of the expense of home buyers. Even within a country, interest rates vary widely, though the home loan interest rates of leading banks and financial institutions are comparable. In September 2015, for instance, the Prime Lending Rate, or the average rate of interest charged on loans by five major Indian banks is 10.

Many local and personal factors influence the rate at which people lend to each other. But, across the country, interest rates are influenced by the Reserve Bank of India. The RBI influences interest rates by raising or lowering the rate (Repo Rate) at which it lends to commercial banks. Commercial banks, in turn, respond to the fluctuations in the repo rate by adjusting the rate at which it lends to general public, including home buyers.

Infographic By Sandeep Bhatnagar

The RBI, for example, cut the repo rate by 25 basis points each in January, March and June 2015. Though the commercial banks were not too fast to cut the base rate, after the repo rate cut in March, they slowly started cutting rates too. HDFC Bank, for instance, has cut the base rate by 65 basis points since April. The RBI's repo rate and Prime Lending Rate in India are closely related to each other.

But, how much effect do interest rates have on home loans? If your home costs Rs 50 lakh, and the mortgage loan interest rate is 5 per cent, your monthly mortgage payment for a 30-year mortgage for would be same of that of a home worth Rs 40 lakh when the interest rate is 7 per cent. This means that interest rates are a major factor that makes your homes affordable. This is why RBI governor Raghuram Rajan said that there are two ways for developers of real estate in India can sell off their unsold inventory. 1) If banks cut home loan interest rates, there would be greater demand for homes. 2) If real estate developers cut home prices, again, the demand for homes would rise.

But, are interest rates the only factor that influences home prices? Generally, home prices are high when interest rates are low, and home prices are low when interest rates are high. This is because when interest rates rise, people are less likely to buy homes. When interest rates fall people are more likely to buy homes. So, in countries like the US, experts advise home buyers to buy homes when interest rates are low. But, in India, as most people take floating rate loans in which interest rates fluctuate, it is better to buy homes when residential property prices are low, like it is now.

Even though prices have been stagnant for a while in the Indian real estate sector, after the prime lending rates in India fell at the end of 2013, and home prices went up in early 2014 according to the National Housing Board Residex.

Infographic By Sandeep Bhatnagar

But, when interest rates decline, deposit rates would fall too. People would be less likely to deposit their savings in banks. We should not forget that interest rates are a price home loan borrowers pay for funds. So, when banks lower interest rates, supply of funds may decline. When supply of funds decline, home buyers would find it difficult to obtain loans. In the long run, home loan interest rates would rise. But, if lowering of interest rates happened because there is greater supply of savings seeking home loan borrowers to accept loans at a lower rates, it is the sign of a healthy economy. Such low interest rates are important for the efficient functioning of real estate markets. For this, a low inflation rate is essential. Consumer Price Index (CPI) inflation in India had been high in India since 2006 though it has declined to low levels in the recent past. If this continues for the next few years, home loan interest rates would decline too.

When inflation is low, people are more likely to deposit their savings in banks because they are likely to receive a higher return from their investments. This is why interest rates are low in countries with low inflation. In 2014, the lending interest rates in the United States was 3.3 per cent and in the UK, it was 0.5 percent. In the same year, in India, it was 10.3, and the lending rate has been in double digits in 2011. This is because inflation rarely rises above 3 per cent in the US, the UK and other developed countries. Low inflation leads to a greater supply of savings seeking borrowers, lowering interest rates for home buyers. Moreover, home buyers would be more willing to borrow because the real estate price appreciation over years would be higher than the interest rates they pay on the mortgage loan.