The Reserve Bank of India (RBI) has already hiked key interest rates 11 times in 18 months to stop the uptrend in inflation. The Repo and the Reverse Repo stand at 8% and 7% respectively. Banks borrow from RBI at the repo rate and deposit with RBI at the reverse repo rate. For banks, this means increase in cost of funds and for the loan borrowers, it means increase in cost of loans. The banks have been quick to pass this extra burden on to the customers. So ultimately it is the loan borrowers who are left to bear the pain.
There are two ways to shoulder this burden. Either by increasing the duration of the loan or by increasing the equated monthly installments (EMI).
Whenever interest rates increase, the banks first try to increase the loan duration because it enables them to earn more. But there are limits to which the duration of the loan can be increased. One cannot increase it indefinitely because of limits relating to the age and income of the borrower and also because it would affect credit quality of the banks. The increase in duration is never beyond the age of 60 - 65 of the borrower. When interest rates rise to a point where an EMI payment cannot cover the interest payment, banks typically raise the EMIs to ensure they cover the interest on loan. The banks have already agreed for zero charges on prepayment of loans and have extended the duration of the loan wherever possible.
So the next option for them is to increase the EMI. Loan borrowers can brace themselves for increase in EMI in the coming months. But it may not be all bad news. Though increase in EMI will stretch the customer's finances in the short-term, it will save them substantial amount in terms of future interest outgo. When the loan duration is increased, the sharp rise in interest outgo happens because interest payments make up a much higher proportion of the initial EMIs and principal repayment gets pushed further into the horizon. As long as the principal remains unpaid, it continues to bear interest. The trade off is short term pain for long term gain.