The marginal cost of funds-based lending rate

Financial institutions use MCLR as a reference benchmark to set lending rates on loans availed by retail customers. The RBI introduced the Marginal Cost of Funds based Lending Rate (MCLR full form) for time-effective transmission of their policy rates to retail lending rates and an overall improvement of transparency in the banking system.

This aims to enhance transparency in the process that financial institutions follow to fix interest rates on various loans and credit facilities. Lenders can also experience a competitive advantage as MCLR comprises an internal benchmark that is tenor-linked and can be reset as per the outstanding repayment period.

The lending rate regime allows financial institutions to charge interest at both fixed and floating rates for different categories of loans. Exclusions to this regime comprise loans extended at a fixed rate of lending for a tenor exceeding 3 years and other special loan schemes. As retail lending rates are set by adding a spread above the MCLR, lenders cannot extend advances below this rate for any loan linked to this regime.

Benefits of MCLR implementation for customers

As the MCLR regime is receptive to policy rate cuts, home loan borrowers experience the effect of changes in the RBI’s rate on their home loan interest rates immediately or as per the reset period.

The lending regime mandates financial institutions to adjust their lending rates immediately with any change in the repo rate. Customers can receive the following benefits of MCLR rate implementation.

• Significant benefits to home loan borrowers during subsequent repo rate cuts implemented by the RBI.
• Swift transmission of RBI’s policy rate changes with a mandated adjustment in home loan interest rates overnight or for reset periods of 1 month, 3 months, 6 months, 1 year, or 2 years.
• Increased transparency as home loan borrowers can visit the financial institution’s website to check current MCLR.

Consider the following example for a better understanding of what the MCLR rate is and how it impacts home loan lending rates.

The home loan interest rate under the MCLR regime stood at 11% in July 2020, wherein the Marginal Cost of Funds based Lending Rate was set at 9%, and the remaining 2% amounted to credit spread. The housing advance carried a reset period of 3 months. Thereby, after 3 months when the internal reference rate dropped by 1.5% to 7.5%, the home loan interest rate reflected an equal drop, coming down to 9.5%. Home loan borrowers thus benefit remarkably from a drop in the internal benchmark rate as per the reset period and the outstanding repayment tenor.

How to calculate MCLR

The Marginal Cost of Funds based Lending Rate is devised as per the incremental cost of lending that financial institutions need to bear. Financial institutions compute their MCLR based on several variables.

The components of the MCLR rate calculation are listed below.

Marginal cost of funds

It takes into consideration all the borrowing that a financial institution undertakes. They include funds availed from different sources such as FDs, savings accounts, loans from RBI at applicable repo rates, current accounts, as well as retained earnings.

Interest rates applicable to these borrowings are considered for the marginal cost of funds calculation. As per the RBI, the formula for such cost calculation is:

MCF = 92% x Marginal Cost of Borrowing + 8% x Return on the Net Worth

Tenor premium

This is a critical element that contributes to MCLR calculation and is decided basis of the length of repayment tenor. It takes into consideration the risk associated with a reset tenor, whereby a longer tenor represents a higher risk and vice versa. The burden of this risk is shifted to borrowers as a tenor premium, factored in as a percentage representation of the risk coverage amount charged. Financial institutions also term it as a discount factor.

Operating cost

It comprises the operational expenses incurred by a financial institution in extending loans to borrowers, excluding all or any service charges levied. The cost also carries charge allocation for other operational expenses incurred during a loan period.

Negative carry on CRR account

Cash Reserve Ratio or CRR represents the amount of cash financial institutions are mandated by RBI to maintain at all times and serves as a token of safety and liquidity. Every loan initiated by the financial institution inversely affects the CRR, which may signify a nil return on the CRR, resulting in a negative carry.

Such a negative carry also indicates the cost of funds exceeding actual returns. Financial institutions account for such returns negatively and allocate related charges in the MCLR set or reset. The following formula is used for the calculation of such a negative carry.

Negative Carry on CRR = The CRR needed x (Marginal cost of funds / (1 – CRR))

After consideration of all these factors, the financial institution arrives at a suitable MCLR that serves as a minimum internal benchmark for setting retail lending rates like home loan interest rates.

What is the MCLR rate on home loans

Home loan MCLR rates are closely linked to repo rates and fund costs of the lender. Therefore, any change in the repo rate will affect the floating rate of interest on a home loan. If the lender brings down the home loan MCLR rate, the floating home loan interest rate will also fall. Although this will not affect the EMI, it will affect the tenor of the loan.

Difference between MCLR and base rate

With MCLR, borrowers can benefit from the repo rate cuts by the RBI. This makes the banking system more transparent. The base rate is the minimum rate of interest that lenders offer on loans to their customers.

MCLR depends on factors such as operating costs, tenor premium, the marginal cost of funds, and the cash reserve ratio (CRR). The base rate depends on various factors such as bank costs, bank deposit rates, profits, etc.

MCLR depends on the changes that the RBI makes to the repo rate. The base rate is independent of the repo rate the RBI sets.

MCLR can vary for different loan tenors. Lenders can choose to change the base rate quarterly.

How to convert a base rate home loan to MCLR

Borrowers may decide to switch to MCLR based home loans from the base rate depending on the actual benefits and transfer costs they receive. Lenders levy their own charges for the switch. Some banks do not charge anything for converting home loans to MCLR. So, by spending a few thousand, borrowers can convert their base rate home loans to MCLR based home loans and benefit hugely in the long run.

Impact of MCLR on home loans in India

Lenders offer home loan MCLR rates at only floating rates. If the borrower has opted for a home loan with a fixed rate of interest, MCLR may not affect the home loan. Whether the borrower will stand to gain or lose will depend on the changes in the repo rate. Current MCLR rates in India are following a downward trend. So, those planning to purchase a house can take advantage of switching to MCLR home loans.

RBI guidelines about MCLR

RBI guidelines state that MCLR will not affect fixed-rate home loans. While computing the marginal cost of funds, lenders must consider deposit balances and other borrowings. Banks must publish their MCLR for different tenors. MCLR on the sanction date of the floating rate home loan will continue until the next reset date.

Also read: RBI guidelines for home loan