The Reserve Bank of India (RBI) has reduced its repo rates by 125 basis points in the last 2 years. Ideally, the banks should follow this up with reduced lending rates, but by April 2016, the banks had passed on just around 60 basis points to the customer. To speed up this process, the RBI has instructed the banks to shift from Base Rate system to Marginal Cost of Funds-based Lending Rates (MCLR).
Under the base rate system, banks had to announce a base rate, a minimum lending rate, which they would charge a customer on loans. The banks could arrive at the base rates on their own, but it had to be approved by the RBI. However, the banks could also add extra spreads and increase the final lending rate, or give special discounts to one set of customers and overcharge another set. This system also did not take into account the repo rates announced by the RBI.
MCLR, on the other hand, is aimed at ensuring that the customer also benefits from the central bank’s policy rates. It is also expected that the MCLR will provide transparency to the process employed by banks to arrive at lending rates. A bank will determine its MCLR based on the following parameters:
According to RBI directive, the banks have to set at least 5 MCLR points - overnight, 1 month, 3 month, 6 month and 1 year. The rates should be reviewed every month but the loans linked to MCLR will be reset with a different interest rate on a yearly or half-yearly basis and not every month. However, if the bank wants to apply a shorter MCLR term to a loan, it is free to do so. The RBI only wants that the maximum tenure of MCLR correction on loans be 1 year, in order to ensure that the rate cuts by the central bank are passed on to the customers in a timely manner.
The MCLR will be applicable to new loans, taken after the bank has announced the rate, and not to existing loans. This means that the banks have to continue announcing base rates as well, for the benefit of the existing customers. However, you can put in a request to switch your loan to the MCLR system and see if the bank agrees.
State Bank of India (SBI) was the first bank to announce MCLR. It announced 7 rates:
In addition to the MCLR, banks can announce spreads – additional basis points applicable on loans – and these spreads will be different for different loan products and customers. The spread depends on credit risk and the period of loan. The credit risk of individual customers will be decided on the basis of their credit scores.
One of the longest-term loans is a home loan. Because of this, lending rate fluctuations will affect home loans the most. Banks will apply either the 6-month MCLR or 1-year MCLR to new home loans taken after April 1, 2016 (or after particular banks announce their MCLRs). If the 6-month MCLR is applied, your home loan interest rates will be reset every 6 months depending on any change in the 6-month MCLR, and if the yearly MCLR is applied, your home loan interest rates will change every year.
This change will directly impact your Equated Monthly Instalment (EMI) amount. If MCLR goes down, your EMIs will also be reduced, and if the MCLR is increased, your EMIs will go up. But to get the benefit of changing MCLR, you need to choose the floating rate home loan and not fixed rate home loan.
Let’s try to understand this with an example. Kotak Mahindra Bank has said that it will use the 6-month MCLR rate of 9.4% for its home financing products. With a spread of 25 basis points, this means that you can borrow from Kotak Mahindra at an interest rate of 9.65%. So if you are borrowing Rs. 40 lakh on floating rate after April 1, 2016, for a tenure of 30 years, your EMI would be around Rs. 34,073. If the MCLR after 6 months slips to 9.3%, then your EMI will come down to Rs. 33,780. But if it rises to 9.5% at some point, then your EMI will be higher at Rs. 34,366.
Since the MCLR system is fairly new and the lending rate difference between MCLR and base rate yet to solidify, it would be better to wait and watch how it progresses before taking a new loan or switching to the new rate system. It is likely that the interest rate differences are marginal and not make a huge difference at the end of the day.
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