Planning to take a loan? Get ready for a higher rate of interest. Those of you have a loan with a floating interest rate will end up paying more now.

If you are an investor who plans to invest in bank fixed deposits, however, you can smile. The interest rate on bank deposits is expected to go up as well.

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Why?

The Reserve Bank of India [Get Quote], in its review of the annual monetary policy, has signalled a rise in interest rates. The signal is part of the government's policy to influence the direction of the economy, via its central bank, by affecting interest rates and money supply.

Before we continue, let's explain some terms.

Reverse Repo

When the RBI borrows money from banks 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.

Repo

When the RBI lends money to banks against their securities, it is known as the Repo rate.
This is what the banks pay the RBI when they borrow money.

So what's happened now?

The RBI has raised both its repo and reverse repo rates by 25 basis points (0.25%). to 5.5%.

It means the RBI is now willing to pay more for the money it borrows and wants a higher rate for the money it lends. It's also a clear signal that interest rates should go up.

The repo and reverse repo rates are the base rates for borrowing and lending in the economy. If these rates are raised, all other rates tend to go up in tandem.

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Why is the RBI raising interest rates?

Despite the rise in oil prices, inflation has not hit the roof.

In fact, the Wholesale Price inflation (the Wholesale Price Index or WPI measures the changes in wholesale prices) is only slightly above 4%.

While the inflation may be low now, the worry is that it could get worse later.
 
How does a interest rate hike work in combating inflation? The RBI's intention is to raise the cost of credit (lending money). If borrowing becomes more expensive, the demand for loans should drop.

The RBI hopes that if interest rates go up, people will not borrow quite so much. If borrowings slow down, so does the pace of growth in the economy. If corporates do not borrow that much, they will not grow that fast and produce less. Rapid growth tends to lead to inflation while a slow down in growth will lead to lower inflation.

What the RBI is doing is locking up the drinks just when the party has begun. The rate hike is a pre-emptive move, aimed at nipping inflation in the bud.

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How does this affect you?

Borrower

Loans are going to be more expensive.

If you already have a floating interest rate loan, get ready for a hike. Either your Equated Monthly Installment (amount you pay every month servicing your loan) will rise or it will stay constant and your repayment tenure will increase.

If you are going to take a home loan, you will have to choose between a fixed or a flexible interest rate loan.

If you want no surprises in the next year or two, you can opt for a fixed rate loan. Here, the interest rate remains constant all through the repayment tenure.

But this will come at a cost. Interest rates on fixed home loans are higher than those on floating home loans. Sure, you get the certainty that home loan rates will not rise, but you end up paying more for it.

The interest rate on a fixed home loan is around 1% to 1.25% higher than that for a flexible home loan.

Investor

If you are investing money, make sure you invest in a floating rate deposit. As and when the interest rates rise, your return too will increase. If you invest in a fixed deposit now, even if the rates rise, you will not benefit from the hike in interest rates.

You can even invest in a floating rate mutual fund. Around 65% to 100% of their investments will be in floating rate securities and the balance in fixed income securities.

If you are investing in a bank 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.

Investing should never be done in isolation of what is happening in the economy. Learn to move with the times.