The Reserve Bank of India had announced an increase in the repo rate from 6.0% to 6.25% on 6 June 2018. For the first time ever, the rate was increased for the second time in a year on 1 August 2018. The repo rate now stands at 6.50% and the reverse repo rate has also increased to 6.25%. The Marginal Standing Facility (MSF) Rate and the Bank Rate have both increased from 6.50% to 6.75%.
Since MCLR determines all kinds of loan rates (except personal loans, which are usually provided on a fixed rate basis), loans are set to become cheaper across the board, including home, auto and personal loans.
Top 5 Things to know about RBI New Loan Rate
In a move to improve the interest rate regime, the RBI introduced the MCLR which was aimed at bringing in more transparency and regulations into the banking world. MCLR is the Marginal Cost of Funds based Lending Rate (MCLR) which is a modification of the base rate system. The question on everyone’s mind is will it affect me? Let’s take a look at how the MCLR will change the way banks lend money, how it will affect your current loan and how it will impact future loans.
What is the need for a New Loan Rate?
Under the old system of base rates, periodic changes in the rates would be introduced by the Reserve Bank of India. This in turn needed to be introduced by banks under their own lending rates schedule. But in reality, banks were reluctant to change their deposit rates and lending rates. Reports showed that when the RBI increased rates, the banks jumped to increase their rates, too. But when the RBI decreased rates, it took a long time for banks to adjust their rates as well. So a need for a better system sprung up. The RBI implemented the new MCLR method in April 2016. Under this system, the banks are required to revise their rates regularly. This will ensure that they keep up with the changes introduced by the RBI.
Understanding MCLR
MCLR may seem complicated but it becomes much easier to understand once you break it down. In economic terms, “marginal” means additional or the change in the current state. So under MCLR, we will be looking at the marginal costs and the MCLR will be based on the marginal cost condition. A number of components make up marginal costs:
- First, we have the marginal cost of funds. This comprises of marginal cost of borrowings and returns on net worth.
- Operating costs which the banks incur.
- Negative carry on account of cash repo rate. This simply means the expenses the banks incur in order to maintain reserves with RBI.
- Tenor premium. This is the higher rate of interest that the bank can charge for long-term loans.
MCLR Calculations
As per the RBI guidelines, marginal costs are charged based on these factors:
- Borrowings meaning the repo rate, long-term interest rate, and short-term interest rate
- The interest rate offered on deposits including savings deposits, current deposits, term deposits, and foreign currency deposits.
- Return on net worth
The Marginal Cost of Funds will be based on these components:
- 92% of the MCLR is determined by the marginal cost of funds, deposit rate and repo rate. The return on net worth will comprise of 8%.
- The MLCR is calculated on the basis of the interest rate offered by a bank on deposits and the repo rate.
- From the MLCR calculations, the base rate will be derived.
- The MCLR will be revised on a monthly basis taking into consideration the repo rate and other rates related to borrowing.
- Based on the MCLR, the bank will have to fix interest rates for different types of customers according to their risk factor.
- The new guidelines direct all the commercial banks to prepare the new internal benchmark lending rates based on the marginal cost of funds.
- Five benchmark rates are required for different tenures which range from 1 day to 1 year.
- The banks have the freedom to set rates for tenures exceeding 1 year.
- Banks cannot lend below the MCLR but there are a few exceptions.
- Banks can lend below the MCLR under these circumstances:
- Loans against deposits
- Loans to employees of the respective bank
Loans linked to MCLR
The important question now arises, how will MCLR affect my loan? If your existing loan is based on a fixed rate of interest, then the MCLR will not be applicable to you. The MCLR will be applicable to all floating rate loans that are sanctioned from April 1st, 2016. In cases of credit renewal, the MCLR will come into effect. Existing borrowers can switch over to the MCLR system if they wish. MCLR-linked loans can include:
- Home loans
- Auto loans
- Loan against Property
- Educational loans
- Corporate term loan
If you borrowed your loan from a Non-Banking Financial company, the MCLR is not applicable. MCLR applies only to banks.
How does MCLR-linked loan works?
Loans linked to the MCLR system will function differently. To understand how MCLR-linked loan works, we must first understand two terms, “Reset Clause” and “Spread”.
- Reset Clause - When you apply for a loan, the MCLR prevailing on the date of sanctioning will be applicable to your loan. You will be allotted reset dates which are usually 1 year. The reset tenure could be lesser based on your agreement with the bank. On the reset date, your interest rate will be changed to the prevailing rate on that date. Let’s look at a hypothetical situation of a loan sanctioned on May 1st, 2016, with a reset period of 1 year. The loan will bear the interest rate prevailing on 1st May 2016, for 1 year. Let’s say the rate is 15% p.a. During the year, the interest rate falls to 10% on September 1st. This will have no effect on your loan. You will continue to pay 15% interest. On 1st May 2017, your allotted reset date, the prevailing interest rate is 13.5% p.a. The interest rate on your loan will drop to 13.5% p.a. for the next one year till the next reset date.
- Spread - MCLR-linked loans are associated with a spread. A spread is an amount the bank charges above the MCLR. The banks can change their rates by 25 basis points. One basis point is one-hundredth of a percentage point. Banks are free to set the range of spread on different loans. For example, if the interest rate offered by the bank is 14.25% p.a. but the prevailing MCLR is only 14% p.a. Then you know that 0.25% is the spread charged by the bank.
What does MCLR mean for existing loan borrowers?
For borrowers who already have a loan sanctioned, they have the option to continue under the base rate system or switch to MCLR. If the borrower chooses to switch over to the MCLR scheme, they cannot go back to the base rate system. To change your loan to the MCLR system, you need to follow these steps:
- Request your bank to link your loan to the MCLR.
- Request the bank to reduce your quantum of spread.
- For the conversion, there may be a one-time fee applicable which you must pay.
Another important question arises here and that is whether it’s advisable to make the switch or stick to the old system? At present, the MCLR-linked loans are cheaper making the option of conversion appealing. But in the future, there is a possibility of the RBI increasing the rates. This will lead to a higher rate of interest on your loan. So to find out if the shift is worth it, you need to take into account the fees payable, the tenure remaining and if the new interest rate is beneficial. You can use an EMI calculator to find out the difference in your monthly payments. If converting to the MCLR regime means you benefit by 25 basis points or more, and you have a long tenure left, then the shift might be a wise. If shifting means only a difference of 10 basis points or less, and you have a short-term left on your loan, it would be better to stay with the basis point regime.
Effects of MCLR
- Transparency - The new loan rate brings in a sense of transparency. Customers are more aware of the change in interest rates and the reasons for them.
- Interest Rate - With the base rate system, the RBI noted that banks were extremely slow in cutting their rates when the RBI slashed the repo rate. But on the other side, when the RBI increased rates, the banks promptly increased their rates as well. The MCLR scheme aims at changing this situation and regulate the interest rates of banks more often according to the cost conditions.
- Reset Clause - The reset clause brings in a mandatory revision of the interest rate of the loans.
- Spread - Reports suggested that banks would initially offer loans with low-interest rates and low spreads. But within a few months into the loan, the banks increased the spread for no justified reason. This was an unfair practice that affected the customer’s loan negatively. With the MCLR system, banks must set a spread on the loan when it is sanctioned. The banks can increase the spread only within the range set. The spread can be changed only in case the profile of the borrower changes.
- Regulations on banks - Banks are now restricted on the spread they can charge during the loan tenure. Banks are also required to publish fresh interest rates on a monthly basis for at least 5 tenures.
Exemptions under MCLR
- MCLR does not apply to fixed-rate loans. If you have taken a car loan, home loan, personal loan or any other loan with a fixed rate of interest, then the MCLR does not apply to you.
- Only banks will follow the MCLR regime. Any loans taken from finance companies and non-banking financial companies will not fall under this system. This includes NBFCs such as India bulls, LIC Housing Finance, Dewan Housing (DHFL), HDFC, et cetera.
- Loans that fall under government schemes are exempt from the MCLR as the rate of interest will be set by the government.
The MCLR is aimed at bringing in a better system that ensures fair practices and better loan terms for the end customer. The Reserve Bank of India is taking steps to change the way the banking world functions and introduce a working model that will allow the RBI to exercise more control over banks and in turn direct the Indian economy in a better direction.
