The cause of the furore was that the Reserve Bank of India [Get Quote] hiked the reverse repo rate from 4.75% to 5% with effect from April 29, 2005.

A repo is a repurchase agreement. It is an agreement between a seller and a buyer, where the seller sells a security and agrees to buy it back later at a fixed price.

By doing so, money becomes available temporarily to the buyer. The difference between the sale and purchase price, the latter being slightly higher, is the interest earned by the lender.

Don't worry if you have not come across something like this before. This takes place between financial institutions and banks that need money for a very short time (a few days maybe).

Before we go further, you need to understand two terms: reverse repo and repo.

Reverse repo: When the RBI borrows money against its securities, the interest rate at which it does so is known as reverse repo. In other words, this is the rate the RBI pays banks when they lend money. This rate has gone up from 4.75% to 5%.

Repo: When the RBI lends money to banks against their securities, it is known as the repo rate. This rate is 6%. This is what the banks pay the RBI when they borrow money. This rate has not changed.

It means the RBI is willing to pay more now for the money it borrows and clearly signals a shift towards a higher interest rate.

No one is saying this will have a huge impact on the interest rate with immediate effect. Being a relatively small increase, it will not significantly raise interest rates.

It just signals the general upward direction in interest rates. An increase of 0.25% is not enough to get loan rates shooting through the roof, but it is an indication of where interest rates are headed.

• Must I pay off my loan or invest?

Loans may get a little more expensive

Even if banks do not increase their lending rates (interest rate on the loan), the rates on home loans and other loans may go up.

When banks charge a rate of interest, they do it with reference to their Prime Lending Rate, also known as the PLR.

Let's say the bank's PLR is 10.5%. If they give you a home loan for 9.5%, they are doing so at 1% below their PLR.

They may give it to you for 10%, which is just 0.5% below their PLR.

So their PLR has not changed, but your loan -- at 10% instead of 9.5% -- is more expensive now.

Once again, I caution you, the rates will not shoot up. They may just inch up marginally.

If this has you worried, maybe you should opt for a fixed rate loan. If you do not mind the slight increase in interest rates, you can go for a floating rate loan. Anyway, floating rate loans are slightly cheaper than fixed rate loans.

• Too many loans? Here's help

Over to the investor

We have explained what happens to the borrower. Now let's talk about investing.

When interest rates rise, fixed income investors are hurt because their money is locked in at a lower interest rate.

When interest rates rise, bond prices fall. That is because the interest rate on the bond is lower than what is being offered right now. So fewer people want to invest in it. As demand for the bond falls, its price falls (just like it does for shares).

This will also affect the Net Asset Value of a mutual fund that has invested in these bonds.

At such times, it is best to invest in a floating rate mutual fund. These are funds that have around 65% to 100% of their investments in floating rate securities. The balance is in fixed income securities.

Floating rate instruments have a variable interest rate (just like you have a floating rate on a home loan). The interest rate changes periodically and is linked to a specified benchmark.

The periodic intervals can be daily, monthly, quarterly or semi-annually.  

• Why has my fund not declared a dividend?

Just like equity mutual funds have the Sensex as the benchmark, the predominant benchmark for floating rate instruments is the Mumbai Inter-Bank Offer Rate, commonly referred to as MIBOR, which changes daily.

Floating rate instruments ensure that investors get a return in line with prevailing interest rates. This means you don't lose when interest rates rise.

In fact, floating rate funds are a good investment option when interest rates are expected to rise.

Franklin Templeton Mutual Fund was the first fund company to launch a floating rate fund in February 2002. Today, there are around 40 such funds.

If you want to invest in a fixed deposit, opt for a short-term maturity. If interest rates stay constant, you can renew it when it matures. If they rise, you benefit by renewing it at a higher rate.

Do remember, investing should never be done in isolation of what is happening in the economy. Learn to move with the times.