When the Repurchase rate (hereafter – repo rate) is reduced, individuals and firms who hold or seek repo-linked loans benefit the most. A reduction in the repo rate simple means that the cost of borrowing has declined. Thus, anyone who holds a personal or student loan, bank financed vehicle or mortgage bond, pays less interest on their loan, provided it’s repo linked.
The repo rate is the rate charged at commercial banks when they borrow money from the Central Bank (Reserve Bank). Individuals themselves cannot borrow money from the Central Bank. However, individuals are affected by changes in the repo rate since this translates into changes in the prime lending rate. The prime lending rate is the default interest rate that consumers and firms are charged when borrowing money from the bank or any other financial service provider.
The prime lending rate is linked to the repo rate, as such, changes in the repo rate entail changes in the prime lending rate. There exists a 3.5% difference between the repo rate and prime lending rate. For example, when the repo rate is 7%, the prime lending rate would be 10.5%. When the repo rate decreases to 6.5%, the prime lending rate would automatically decrease to 10%.
Banks however, have the discretion to charge individuals interest rates higher than the prime lending rate depending on the individual’s risk profile or credit score, hence the so called “prime plus”. An individual who is considered high risk would usually be charged higher interest while an individual who is considered low risk, would be charged favourable interest rate.
Here is a simplified example. Tom borrows R5000 from the bank at an interest rate of 15% per annum during which the repo rate is set at 7% and the prime rate at 10.5%. This means that Tom was charged prime plus 4.5% which then makes it 15%. Tom in this regard pays R750 in interest per annum (R5000 x 15% = R750). If the central bank reduces the repo rate from 7% to 6% (by 100 basis points), the prime rate will automatically become 9.5%. This means Tom’s new interest rate will be 14.5%, bringing about a cash saving of R25 (R5000 x 14.5% = R725). When the repo rate was 7%, Tom used to pay R750 in interest payments, when the repo rate is reduced to 6%, Tom pays R725 in interest. This means Tom now saves R25 on his annul instalment.
The result of low interest rates has increased spending which raises the profits of non-financial firms. Furthermore, through the multiplier effect, low interest rates can result in business expansions, employment and reduced loan delinquencies.
It is worth noting however, that lower (nominal) interest rates discourage savings. As the repo rate is reduced, so are the bank deposit rates. This discourages individuals to save money in the bank. Also, if inflation increases as a result of the reduction in the repo rate cut, investors become worse off.
