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  • MCLR vs. Base Rate

    In the recent weeks, some of the leading financial institutions in the country have revised their Marginal Cost of Fund based Lending rate (MCLR) and base rate in a move that has proven to be beneficial for millions of customers. In fact, others are expected to follow suit soon.

    However, considering that the implementation of the two rates is separated by a period of almost five years, there are many customers whose loan interest rates are determined by the previous benchmark, that is, the base rate. Hence, such people are left wondering if they should switch their home loans, or any other loan, to the MCLR system and benefit from the reduced rates. Before arriving at a definite conclusion, it is important to understand what the two terms actually mean.

    Differences Between MCLR and Base Rate

    The MCLR and Base Rate may appear to be quite similar on the surface. After all, they were implemented with the same objective in mind and are loosely based on similar principles. However, there are crucial factors in each case which separate the two rates. The differences have been tabulated as shown below.

    Base Rate MCLR
    Based on average cost of funds Based on marginal/incremental cost of funds
    Calculated by considering minimum rate of return/profit margin Calculated by considering tenor premium
    Base is also governed by operating expenses, and expenses needed to maintain cash reserve ratio The MCLR is also determined by considering deposit rates and repo rates, along with operating costs and cost of maintaining cash reserve ratio

    Marginal Cost of Fund Based Lending Rate (MCLR)

    The Marginal Cost of Fund based Lending Rate refers to the minimum interest rate a bank must charge for lending. The bank cannot grant any loan below that rate, except in certain cases permitted by the Reserve Bank of India (RBI).

    The MCLR now serves as a benchmark and was introduced to counter the base rate system. It has been in effect since April 1, 2016, for all the categories of domestic rupee loans. Simply put, starting from April 2016, interest rates for every single loan, irrespective of the category, will be governed by the MCLR.

    The MCLR is determined by the current cost of funds, in contrast to the base rate, which is governed by the average cost of funds. The MCLR was introduced by the RBI because rates based on this system are more receptive to the changes in the policy rates. This also ensures that the country’s monetary policy is implemented effectively across all spheres.

    As a result, the MCLR ensures that the lending rates of banks reflect the policy rates. Moreover, it also provides transparency in the procedure followed by banks to arrive at interest rates on advances.

    Factors that Determine the MCLR

    In economics, the term ‘marginal’ refers to a specific change in quantity in its current state. Hence, the MCLR takes into account the current cost or incremental cost of funds. Based on this concept, let us understand the factors which determine the MCLR.

    • Marginal Cost of Funds: It comprises of marginal cost of borrowings, along with return on net worth. The marginal cost of borrowings holds 92 percent influence, while the other component holds only 8 percent. It also depends on repo rate and the interest rates charged by banks.
    • Operating Costs: These costs are associated with providing the loan, raising funds, and running the day to day operations.
    • Cost of Carry in the Cash Reserve Ratio (CRR): The banks have to take into consideration the cash deposits they need to keep with the Reserve Bank of India.
    • Tenor Premium: This is essentially the premium that will be charged for long-term loans to mitigate the risk associated with long-term lending.

    Every month, banks may publish the internal benchmark (MCLR) for overnight, one-month, three-month, six-month and one year maturities.

    Base Rate

    Before the implementation of the MCLR, loans in every category fell under the purview of the base rate. This came into effect in July 2011, prior to which it was the benchmark prime lending rate (BPLR) that was the governing factor. In short, the base rate replaced the BPLR.

    Just like the MCLR, the base rate is the minimum interest rate below which a bank cannot lend. Here as well, exceptions exist in certain cases allowed by the RBI.

    The idea behind implementing the base rate was quite similar to the implementation of the MCLR - to improve the transmission of monetary policy and to make the methodology of lending rates selection by banks more transparent.

    The key point here to remember is that the base rate is determined by the average cost of funds, in contrast to the MCLR that depends on the current cost of funds.

    Base Rate Calculation

    Just like the MCLR, the base rate is calculated keeping certain factors in mind. Each bank is free to determine their own base rate, based on the norms provided by the RBI. According to the bank, the base rate must be determined by considering the following factors:

    • Average Cost of Funds: This is the interest rate given on the deposits.
    • Operating costs/Unallocatable Overhead Costs: These are the expenses that go into running the day to day operations and includes several components like legal expenses, depreciation, administrative costs, cost of stationery, et cetera.
    • Negative Carry in the Cash Reserve Ratio: This is the cost that the banks need to incur in order to keep a specific amount of cash reserves with the RBI.
    • Margin of Profit/Average Return on Net Worth: This figure indicates the profitability and net amount obtained.

    As a result, the base rates may vary from bank to bank, owing to differences in one of these factors. In most cases, it is the difference in the interest rates provided on deposits.

    Should You Shift Your Home Loan from Base Rate to the MCLR?

    The introduction of the MCLR has certainly made things a whole lot simpler and convenient for prospective home buyers. Many leading banks in the country have slashed their MCLR in order to keep up with the competition, thus creating a platter of appealing loan options to choose from.

    State Bank of India is setting the example for others to follow. It’s one-year MCLR currently stands at 7.95 percent, and recently, it slashed its base rate too. SBI’s revised base rate is 8.65 percent and is set to benefit millions of existing customers.

    Bank of Baroda is another state-owned financial institution that cut its MCLR and took everyone by surprise. It is now offering home loans at one-year MCLR of 8.30 percent.

    Private banks like ICICI Bank, Axis Bank and HDFC Bank are not far behind either. ICICI Bank and Axis Bank are offering home loans, starting at 8.35 percent. HDFC Limited too is offering home loan at 8.35% - 8.60%.

    Needless to mention, borrowers who availed loans after April 1, 2016, are enjoying the benefits of reducing rates. However, even the customers who took loans before April 2016 can enjoy these benefits by simply switching from base rate to MCLR.

    How to Go About Switching?

    Switching from base rate to MCLR is a fairly straightforward process, provided the cost of transfer and actual benefits have been researched thoroughly. The cost of switching can be anywhere between Rs. 5,000 - Rs. 20,000, depending on the banks.

    One thing that needs to be considered is the amount saved from the switch. For instance, consider that you have taken a home loan of Rs. 50 lakh at 9.90 percent under base rate. At the end of three years, you have paid an EMI of Rs. 47,920, while the total interest on the same is Rs. 14,46,857. The outstanding loan balance on the same is Rs. 47,21,727.

    Particulars Implications for the First Three Years
    Outstanding balance at the start Rs. 50,00,000
    Interest rate based on base rate 9.90 percent
    EMI Rs. 47,920
    Total interest paid for the first three years Rs. 14,46,857
    Total interest to be paid for the 20 years Rs. 65,00,857

    If you choose to stay with the base system, then you will have to pay a total interest of Rs. 50,54,010 over the next 17 years.

    However, if you switch to the MCLR system at your present lender, then you stand to save a huge chunk, as illustrated below.

    Particulars Ramifications of the Switch After 3 Years
    Outstanding balance Rs. 47,21,727
    Interest rate based on the MCLR 8.40 percent
    EMI Rs. 43,546
    Total interest due for 17 years Rs. 41,61,650

    As you can see, post switch, the total interest you would have paid at the end of 20 years is the sum of interest paid for three years under the base system and the interest paid for the other 17 years under the MCLR system. This amount comes to Rs. 56,08,507.

    Hence, it’s evident that if you choose to switch your home loan to the MCLR system at the end of the third year, then you stand to save roughly Rs. 9 lakh on interest payments!

    Sometimes, you may get better rates with a different lender, rather than your present one. Even in this situation, it is possible for you to switch your home loan to the other lender and this process is known as refinancing. The example mentioned above holds good for this situation too.

    Switching Costs to Be Considered

    Charges such as legal fee, processing fee, stamp duty, et cetera, can be levied while shifting your home loan to the MCLR rate, or to another lender. Remember, you should opt for the switch only if these charges are negligible in comparison to the savings you will make after the switch. Hence, all terms and conditions, along with charges and rates need to be examined carefully before arriving at a conclusion.

    The ideal scenario would be switching to a lender that offers low interest rates with minimal processing fees. Considering that the financial institutions have lowered the MCLR rates for all tenures, now appears to be a good time to make the switch from base rate.

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