Effect Of Inflation on Home Loan Interest Rates

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10 MAY, 2023

The current increase in the cost of goods has left many of us wondering about the effect of inflation on interest rates. Inflation refers to the general rise in the prices of goods and services over time. Various factors, including inflationary pressures such as supply-chain issues, fiscal policies, global commodity prices, climatic factors, etc., can cause this.

The concept of “how interest rate affects inflation” is complex, as interest rates often rise in response to rapid inflation. Banks use interest rate hikes as a tool to help control inflation. However, understanding the intricacies of this relationship requires a deeper analysis of economic factors and the expertise of economists.

If you have a good credit history and no missed payments, you can negotiate a lower interest rate on your Home Loan with your lender. However, it's essential to remember that the economic factors driving "how interest rate affects inflation rates" may not be as straightforward.

The Historical Relationship between Home Loan Interest Rates and Inflation

Let's examine the effect of inflation on interest rates by analysing data from the past few years. In the previous five years, the Reserve Bank of India (RBI) gradually lowered the repo rate to strengthen the economy.

Here’s how India's GDP growth rate and repo rate changed from 2016 to the present. The country's growth rate slowed to 4.04% in 2019 from 8.26% in 2016. This downturn worsened, and the GDP shrank by 7.96% in 2020. During this sluggish phase in the Indian economy, the RBI reduced the repo rate by 275 basis points to 4%, its lowest level in at least 15 years.

The RBI could deliver a series of interest rates with inflation mostly remaining within its tolerance limit of 2%-6%. If inflation had risen substantially above 6% during this economic slowdown, the RBI would have found it challenging to provide as many rate cuts as it had in the previous years.

The Current state of Home Loan Interest Rates and Inflation

Starting from May 2022, the Reserve Bank of India has been increasing the key lending rates to control inflation in the country, following two years of maintaining the status quo. The repo rate has been raised by 225 basis points so far, and many banks have already passed on around 200 basis points of this hike to their Home Loan borrowers.

For example, if a 32-year-old individual took out a Home Loan of Rs 30 lakh for a 20-year tenure at a 6.95% interest rate in April 2022, their Equated Monthly Instalment (EMI) would have been Rs 23,169. However, due to consecutive rate hikes by the RBI, their Home Loan interest rate with inflation rate has increased to 9.20%. They must pay around Rs 26,000 in EMI for their current outstanding Home Loan (assuming they have already paid EMIs for 11 months).

Factors that Influence the Relationship Between Home Loan Interest Rates and Inflation

Inflation can significantly impact Home Loans as it can lead to a gradual increase in prices over time, reflecting the overall state of the economy. It happens because lenders seek higher interest rates as compensation for the decline in the purchasing power of the money they receive in the future. To ensure that their interest returns remain a net profit, lenders typically maintain interest rates at a level that compensates for the loss of purchasing power due to inflation.

For instance, suppose the Home Loan rates are 5%, but the annual inflation rate is 2%. In that case, the actual return on loan concerning the purchasing power of the money the lender receives back is only 3%. Due to this, Home Loan lenders keep a close watch on the inflation rate and adjust their rates accordingly.

Implications for Homebuyers and Homeowners

The impact of how does inflation affects interest rates is not uniform, as various factors come into play for different categories of borrowers. Borrowers with smaller loans tend to be less affected by rate hikes, whereas those with larger loans and floating interest rates can face difficulties.

The reason for the immediate impact on floating rate borrowers is that their interest rates are linked to a benchmark, such as the repo rate. Any changes in the model are reflected in the floating rate within a quarter. Investment homebuyers typically opt for higher loan amounts as they plan to use the property as an investment vehicle or rental.

As a result, they are more likely to be impacted by rate hikes in the floating interest option. Homebuyers would have to pay more in interest. Contrarily, self-occupied affordable homebuyers with lower loan amounts are less likely to be affected by rate hikes, as explained by the rate differentials.

Conclusion

Home Loans make up approximately 65% of all outstanding bank loans in India, and many of these borrowers have opted for floating rate loans. It makes them susceptible to interest rate hikes.

Regardless of the borrower category, the best way to avoid defaulting on a loan is to plan expenses ahead of time and budget effectively.

FAQs

1. How do central banks use interest rates to control inflation?

Here’s how interest rate affects inflation: When interest rate and inflation in India are low, it incentivises people to borrow more money from banks and save less, which leads to an increase in the money supply and overall demand in the economy. It can cause the prices of goods and services to rise, leading to inflation.

To combat inflation, the RBI may increase interest rates to reduce the money supply and decrease overall economic demand. It is because the higher interest rate and inflation in India rates make borrowing more expensive and saving more attractive. It helps decrease the money supply in the economy and lessen inflationary pressures.

2. Why do interest rates increase during inflation?

Increasing the bank rate is one of the tools used by the RBI to control inflation. When the bank rate is increased, it becomes more expensive for commercial banks to borrow from the central bank. As a result, banks tend to lend less to customers by increasing the Home Loan interest rate.

3. What is the effect of inflation on banks?

When the interest rate in inflation is low, people tend to borrow more and save less. It increases the money supply in the economy and ultimately causes inflation. In such a case, the RBI typically increases interest rates in inflation to reduce the money supply. It can lead to people borrowing less and saving more, as higher interest rates incentivise saving and discourage borrowing.

4. Can inflation have a positive impact on interest rates?

When inflation increases, it erodes the currency's purchasing power. It means that the same amount of money can now buy fewer goods and services than before. To combat this, the central bank may increase the Home Loan interest rate, making borrowing more expensive and saving more attractive.

Understanding the Relationship between Inflation and Home Loan Interest Rates in India