MCLR rate and its effects on loans demystified

MCLR stands for Marginal Cost of Funds based Lending Rate. A bank determines its minimum interest rate by considering factors such as its cost of funds, operating costs, and profit margin. Banks use MCLR to calculate the interest rate on various loans, including home loans. The interest rate on a home loan is usually set at a fixed percentage above the MCLR, known as the "spread."

When the MCLR changes, the interest rate on loans linked to it also changes. This means that the EMI amount will increase or decrease depending on the direction of the MCLR movement. In general, a lower MCLR will lead to lower interest rates and, thus, lower EMIs for borrowers. A higher MCLR will lead to higher interest rates and higher EMIs for borrowers.

It is important to note that MCLR is not the only factor that determines the interest rate on a home loan. Other factors, such as the borrower's credit score and the loan tenure, also play a role in determining the final interest rate.

MCLR Rate

MCLR was designed to address issues associated with the base rate regime and to enable borrowers who take loans. This also includes home loans and helps the borrower to take advantage of the rate cut imposed by the RBI.

Today, as a borrower, you have the option to shift loans taken before April 1, 2016, to the MCLR mode and avail the benefits of the apex bank’s rate cuts. Loans taken on or after this date are linked to the MCLR. Read on to know what exactly MCLR is and how it affects the borrowing exercise.

MCLR refers to the minimum interest rate below which financial institutions cannot lend, except in certain cases. Earlier, when banks and financial institutions did lend on base rates, its prime customers used to get undue advantages.

For example, if the base rate of lending was 7%, certain financial institutions would lend to their prime customers at 7% or below. Alternatively, for ordinary customers, this rate of interest could have been 10-12%.

Since base rate was a financial institution’s internal policy, this caused a huge monetary loss. Also, even after rate cuts, a lot of time was taken by financial institutions to lower their lending rates and pass the benefits to customers.

Base Rate

A Base Rate is a benchmark interest rate used by banks in India to determine the minimum lending rate for most loans. It was introduced by the Reserve Bank of India (RBI) in July 2010 to replace the Benchmark Prime Lending Rate (BPLR) system.

The Base Rate is determined by individual banks and serves as a reference rate for setting lending rates for various loans, including home loans, personal loans, and business loans. The Base Rate takes into account various factors, such as the bank's cost of funds, operating expenses, and profit margin.

It is important to note that the Base Rate system has been replaced by the Marginal Cost of Funds Based Lending Rate (MCLR) system in April 2016 to enhance the effectiveness of monetary policy transmission and increase transparency in the interest rate setting process. As a result, most banks in India now use the MCLR system to determine their lending rates.

Please be aware that financial systems and policies may evolve, and I recommend checking with individual banks or financial institutions for the latest information on interest rate benchmarks they currently use.

Difference between MCLR and Base Rate

The main difference between MCLR and the Base Rate lies in their calculation methods and responsiveness to policy rate changes:

• MCLR is calculated based on the marginal cost of funds, considering various funding sources and RBI requirements. It is more responsive to policy rate changes, offering transparency and periodic revisions for borrowers.
• Base Rate, determined by individual banks, considers costs, but it may not reflect actual funding costs and lacks responsiveness to policy rate changes.
• MCLR's advantages led to its introduction by RBI in April 2016, promoting effective monetary policy transmission and transparency. Most Indian banks now use the MCLR framework.

How to calculate MCLR?

The Marginal Cost of Funds-based Lending Rate (MCLR) is calculated by banks in India based on specific formulas and guidelines provided by the Reserve Bank of India (RBI). While the exact calculation methodology may vary slightly between banks, here is a general overview of how MCLR is typically calculated:

1. Components of MCLR: MCLR comprises four main components, which are used to determine the lending rate:
   a. Marginal Cost of Funds (MCOF): This represents the incremental cost incurred by the bank for obtaining additional funds. It includes the cost of deposits, borrowings, and other sources of funds.
   b. Negative Carry on Cash Reserve Ratio (CRR): Banks in India are required to maintain a certain portion of their deposits as cash reserves with the RBI, which does not earn any interest. The cost associated with this non-earning reserve is considered as the negative carry on CRR.
   c. Operating Costs: This includes various operational expenses incurred by the bank, such as employee salaries, administrative costs, rent, utilities, etc.
   d. Tenor Premium: Banks apply a premium over the MCOF to account for the loan tenor, as longer-term loans generally carry a higher risk. This premium is determined based on the average maturity of bank liabilities.
   
   
2. Calculation Methodology: The MCLR is typically calculated using the following formula:
   MCLR = MCOF + Negative Carry on CRR + Operating Costs + Tenor Premium
   The MCOF is calculated by considering the cost of different sources of funds used by the bank, such as the cost of deposits and borrowings. This cost is determined based on the interest rates or rates of return associated with these sources.
   The negative carry on CRR is calculated by considering the proportion of deposits that banks are required to maintain as cash reserves with the RBI, multiplied by the CRR rate and the cost of funds.
   The operating costs are calculated based on the bank's actual expenses associated with its operations.
   The tenor premium is determined by assessing the average maturity of the bank's liabilities and applying a premium to reflect the risk associated with longer-term loans.
   
   
3. Review and Revision: Banks review their MCLR periodically, typically on a monthly or quarterly basis, to incorporate changes in their funding costs and other relevant factors. The MCLR can be revised based on the bank's assessment of its cost structure, interest rate movements, and other economic factors.
   It's important to note that the exact methodology and calculation formula for MCLR can vary between banks, as they have some flexibility in determining their own MCLR based on the guidelines provided by the RBI. Therefore, it is advisable to refer to the specific methodology and guidelines of the respective bank to get accurate and up-to-date information regarding their MCLR calculation.

Additional Read: All you need to know about MCLR based home loans

However, the current Marginal Cost of Funds based Lending Rate (MCLR) aims to:

• Bring the much-needed transparency in financial institutions while determining their interest rates
• Pass the benefits of reduced interest rates to customers
• Ensure availability of loans to customers that is fair to both customers as well as the lender

Also, under MCLR, it is mandatory for banks to declare their overnight, 1-month, 3-month, 6-month, 1-year, and 2-year interest rates every month. Now you, as a borrower, can know the MCLR rates of banks from their websites.

With pre-approved offers on home loan, business loan, and personal loan among others, availing finance is an easy and hassle-free affair. Know about your pre-approved offer within seconds by providing a few basic details.

With MCLR rates pushing up EMIs, you can take certain steps to reduce its impact. Two effective strategies are:

If you have availed of a loan after April 1, 2016, then it is automatically linked with the MCLR mode. However, if your loan was taken before this date and linked to the base rate regime, you can always switch to the MCLR mode. If your loan is nearing completion of its tenure, it is better to stick with the base rate.