Interest rate cuts by RBI from February 2015 to April 2016. Graphics: PTIEach time the Reserve Bank of India (RBI) cuts its key policy rates, the common man finds himself surrounded by market talk wherein the so-called experts go on and on about the benefits of lower interest rates. However, the real benefits that are passed on to the common man often fall short of the claims that experts make since a lot of factors are overlooked.
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The Reserve Bank of India on Tuesday cut its policy interest rate by a quarter percentage point, lowering it to a more than five-year low while dangling the prospect of another cut later this year if inflation trends stay benign.
So, how does a rate cut percolate down to our daily lives?
A rate cut by the RBI means a reduction in either the repo, the rate at which banks in India borrow from the central bank or the reverse repo, the rate at which banks park their funds with the RBI. A reduction in key policy rates by the RBI injects more liquidity into the monetary system.
Not every rate cut has the same effect on the end consumers, according to Dr. Mohan Varghese, an economic media consultant. He is of the view that a rate cut will have different impacts in each sectors of the economy and hence the way it affects the common man may vary.
Below are some of the key areas of our lives that are impacted by a change in policy rates.
i) Interest rate on bank loans
There are two types of home loans: floating rate loans and fixed rate loans.
Floating rate loans are the ones that are market-linked and thus the interest payout on such loans keep fluctuating in tandem with the central bank's policy rates and a subsequent revision by the lending bank. Whereas, under fixed rate loans the interest rate is fixed and the market fluctuations do not affect the interest payout on your borrowed capital.
Commercial lenders have started slashing their lending rates and home loans have become much more affordable now. Graphics: Vinod A S Gaurav Mashruwala, a certified financial planner (CFP), says that an interest rate cut will affect the common man depending upon the type of home loan that the existing borrower has taken. And if one is ing to take a home loan then interest rates will be an important factor.
If you were in two minds about buying your dream home because of high interest rates on home loans, it may be time to take the leap. Commercial lenders have started slashing their lending rates and home loans have become much more affordable now, depending on the type of loan one chooses.
Look at it this way - the central bank has been cutting rates in its last three policy reviews. While a fall in crude prices and its impact on the country's export bill has given the RBI some headroom, the central bank may reverse its policy as soon as the economy heats up and commodity prices bounce back. The central bank can very well start raising its key policy rates to maintain a healthy rate of inflation.
Now that the banks have started reducing interest rates, it may be time to go for a fixed rate loan as this helps one lock in at lower rates. However, one should be wary of taking a floating rate loan because there are chances of interest rates going up again in the future.
ii) Start-ups
Availing a loan to start a business can be a tedious task. While lower interest rates can be one of the favourable factors to start a business, one should also consider other aspects such as government policies, the broad industry trend, location, financial viability and the timing among others factors before taking the plunge. One should not blindly follow a business trend, say experts.
When interest rates are reduced, banks and other lending institutions tend to compete with each other to offer the best rates to attract customers. Graphics: Vinod A S"For small businesses and start-ups, the interest rate that they pay on the borrowed capital plays an integral part in their financial planning. Like there are several expenses for a firm, one of them is the interest that they pay on the borrowings," says Harshvardhan Roongta, a CFP and founder of Roongta Securities.
"So when the cost of the capital comes down, there is capacity available for them to expand or think of expansion," adds Roongta.
Some of the factors to start a business are time, capital, rate cut, govt policy, etc. Graphics: Vinod A SWhen interest rates are reduced, banks and other lending institutions tend to compete with each other to offer the best rates to attract customers. So you can opt for the institution that offers you a loan at the most favourable rate. One should also look for the terms and conditions of repayment before availing a commercial loan.
iii) Lower Prices
A fall in commodity prices can do more harm to you than good if you choose to use the opportunity to spend on consumables. Graphics : Vinod A SKartik Jhaveri, a CFP and founder and director of Mumbai-based consulting firm Transcend Consulting, said, "If a manufacturing company has taken a loan, lower interest rates will translate into lower cost of manufacturing. This means, structurally every other financial aspect will go down. But it is not a general rule or a set pattern that it will happen for sure."
Pointing out the effect that lower oil prices have on the prices of commodities, Jhaveri said that it is not the same case with lower interest rates though. "So it is not necessary that the prices of the commodities have to come down when interest rates go down," he said.
For instance, a fall in prices prompts one to spend more. A lower return on savings is no reason to loosen your purse strings. Thus a fall in commodity prices can do more harm to you than good if you choose to use the opportunity to spend on consumables.
On the other hand, if one uses the fall in commodity prices to invest in say gold or appreciating assets such as real estate, then it is better to buy more when the prices are low and book profits when they rebound.
iv) Job Market
When interest rates fall and capital becomes cheaper, companies start expanding their operations and would require more manpower. Graphics: Vinod A S When interest rates fall and capital becomes cheaper, companies start expanding their operations and would require more manpower. This creates more employment.
"Companies carry out their expansion plans when interest rates are lower as it enables them to raise capital at lower cost. When companies build capacity, jobs are created," Roongta said.
Historically, there has been a negative correlation between interest rates and job creation. However, when the rate of inflation rises sharply, companies start cost cutting and as a result retrench part of their workforce. Therefore, one has to be prudent while changing jobs and the mere lure of a better compensation should not be the only deciding factor.
v) Real Estate
The real estate sector sees higher demand when interest rates are cut. Apart from the lower cost of borrowing, a revival in a number of other rate-sensitive sectors and higher employment also spurs demand for the real estate sector.
A pick up in the economic activity and job creation result in higher demand for housing. Demand for housing from the middle class common man is seen growing during these phases, said Mashruwala.
When interest rates on bank loans come down, more people will avail such loans to buy assets including real estate. The up-tick in the market continues until the seemingly ever-growing demand for land and housing causes an astronomical rise in prices to a point of having no takers.
When interest rates on bank loans come down, more people will avail such loans to buy assets including real estate. Graphics: Vinod A SOne has to keep in mind that price rise affects small transactions the most. Since the country's real estate sector is still unorganised and a regulatory body for the sector is yet to be formed, there is no uniformity in prices. As a result, it is the common man looking to purchase a small piece of land who will have to shell out more money.
Lower interest rates are of little help to people who do not have enough funds to use the opportunity to invest in appreciating assets. They also lose out on a higher return as their savings or fixed accounts generate only a lower rate of interest.
A period of lower interest rates is a good time to build a long term investment portfolio. But then, those who are not savvy in the field may burn their fingers in the game of investing. At the same time, a lot of so-called consultancy firms that mushroom with a pickup in market activity also swindle money from unsuspecting investors.
vi) Economic Productivity
"The industry demands for the reduction in the interest rates, we see that the large scale benefits of a reduction in interest rate is on the entire economy as a whole. It has a 360 degree effect on the entire economy," says Roongta.
Rate cut has a 360 degree effect on the economy. Graphics: Vinod A SEveryone wants interest rates to come down. But when interest rates come down, a section of the society, such as the pensioners, who are dependent on interest income, are affected. When interest rate comes down, the earnings on their deposits go down," he said.
It is unwise to park your funds with the bank when interest rates are trending down. It is because the earnings on your fixed deposits will be negligible at a time when the economic activity is relatively high.
So what to do with the surplus cash in hand? This is a good time for you to buy land, gold or invest in business. The rate of return is much higher on investments during these phases.
Food for thought
a. This is not the time to deposit in banks. Liquidate short term FDs and invest in less risky mutual funds or government infrastructure bonds. However, keep long term FDs safe.
b. Invest wisely. Do not put all your eggs in one basket. A little of gold, real estate and mutual funds will not hurt you so bad like a lot of money in just one of those things. Profit can be ensured from one of these investments according to the changing market.
c. Loans can lure you with less amount of interest rate right now, but this can be a trap for you in the future when the interest rate is hiked up. In short, interest rate cuts can be a blessing or a curse in disguise depending on your move. After all, it is your money, think wisely. You can end up in the pit or in the palace. It's your call.
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