• How MCLR Base Rate affects on Loans

    There’s a new buzz of MCLR but what exactly is it? Will it affect your loan? Will it affect future loans? The Reserve Bank of India took the step to change the way interest rates function in the country. But we will have to wait and see if the new regime will have an effect on the banks.

    Why MCLR?

    As the need for bettering the lending rate system was rising, the Reserve Bank of India introduced a new method called Marginal Cost of Funds based Lending Rate (MCLR) in April 2016. This new regime is a modification of the old base rate system. MLCR calculations are done on the basis of the interest rate offered by a bank on deposits and the repo rate. The base rate will then be derived on the basis of the MCLR calculations. According to the new guidelines, commercial banks will have to prepare the new internal benchmark lending rate based on the marginal cost of funds.

    In the old base rate system, the banks took time to change their interest rate according to the changes in the repo rate. Though there were periodic rate changes from the RBI, banks were reluctant to change their own deposit rates and lending rates.

    Based on the MCLR, the bank will have to fix interest rates for different types of customers according to their risk factor. Five benchmark rates are required for different tenures which range from 1 day to 1 year. The banks are free to set rates for tenures exceeding 1 year. The MCLR will be revised on a monthly basis taking into consideration the repo rate and other rates related to borrowing. Banks cannot lend below the MCLR but there are a few exceptions. For loans against deposits and loans to employees of the respective bank, banks can lend below the MCLR.

    What is MCLR?

    When we breakdown Marginal Cost of Funds Lending Rate, it becomes simpler to understand. The term “marginal” in the economic sense means additional or could mean the change in the current state. So the MCLR will be based on the changes in the cost condition which we can refer to as the marginal cost conditions. There are different components that make up the marginal costs.

    • Marginal cost of funds which comprises of marginal cost of borrowings and return on net worth
    • Negative carry on account of cash repo rate which is the cost banks incur to keep reserves with RBI.
    • Operating costs incurred by the banks
    • Tenor premium which is the higher interest that can be charged for long term loans.

    Marginal costs are charged based on the following factors as per the RBI guidelines:

    • Interest rate offered on deposits including savings, term, and current and foreign currency deposits.
    • Return on net worth
    • Borrowings meaning the repo rate, short term interest rate, and the long term interest rate

    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%.

    What kind of loans will be linked to the MCLR?

    All floating rate loans that are sanctioned from April 1st, 2016, will be based on the MCLR. For credit renewal as well, the MCLR will apply. For existing borrowers, there will be an option to switch over to the MCLR system. Floating rate loans include:

    The MCLR is relevant only to banks. So any loan with a floating interest rate sanctioned from a bank will be linked to the MCLR. Some banks have also linked their auto loans and educational loans.

    How does a MCLR-linked loan work?

    Under the MCLR scheme, loans will work differently from the base rate regime. Two terms you should familiarise yourself with is “Reset Clause” and “Spread”.

    Reset Clause - On the day your loan is sanctioned, the MCLR prevailing on that day will be applicable on your loan. There will be reset dates allotted to your loan, and the interest rate will change to the MCLR prevailing on the reset date. The periodicity for a reset is usually 1 year or lesser depending on the agreement with the bank.

    For example, your loan is sanctioned on April 1st with a reset period of 1 year. The prevailing MCLR on 1st April 2016 is 10% per annum. This will be your interest rate for 1 year. If the rate falls to 8% during the year, this will not affect your rates. Your loan will continue at the same 10% as it is valid for 1 full year. On 1st April 2017, the interest rate will change to the prevailing rate on that day.

    Spread - Now the loans linked to MCLR will come with a spread. Banks can spread their MCLR over 25 basis points. The spread, in simple terms, means the amount or margin that you have to pay over the MCLR. Banks are free to set the range of spread on different loans.

    For Example, if the MCLR is 11%. But the rate of interest offered by the bank is 11.25%. The difference is the spread imposed by the bank, i.e., 0.25%.

    What does MCLR mean for existing loan borrowers?

    Existing borrowers have the option to continue under the base rate regime or switch to MCLR. Once the switch is made, it cannot be reversed. To make the switch, the customer needs to request the bank to link the loan to MCLR instead of the Base Rate. You can request the bank to reduce the quantum of spread. There may be a one-time charge applicable for the conversion. Presently, MCLR-linked loans are cheaper than the base rate loans. So a switch could be a good idea. However, customers must keep in mind that if the RBI hikes the rates, this will result in a hike in the rate of interest. Take into consideration the cost of shifting the loan to MCLR and the benefit in interest rates. If the shift amounts to 25 basis points or more, and you have a longer tenure on your loan, then the shift is advisable. But making a shift for a difference of 10 basis points may not be beneficial.

    Effects of MCLR

    Regulation in Rate Changes - Under the old system of base rates, the RBI noticed the banks were prompt to increase interest rates on floating rate loans when the RBI increased rates. But on the other hand, when the RBI slashed rates, banks were slow to cut their rates. The aim of the MCLR system is to change this pattern and get banks to change their rates regularly according to the changes in cost conditions.

    Effect on spread - The RBI also noticed that banks would initially offer low interest rate loans at very low spreads. This would be appealing to the customer. But after a few months, the banks would increase the spread for no legitimate reason. Even if the base rate was not increased, the spread would be raised, therefore resulting in an unfair rise in interest rates for the customer. Under the MCLR, banks are required to set a spread chargeable to the customer at the time of sanctioning the loan. The spread cannot be increased unless the customer’s credit profile changes. Furthermore, banks have to reset the interest rates on loans at least once a year.

    Transparency - Overall, the MCLR brings in more transparency for the customer. The pricing of floating rate loans will be clearer.

    Effect on banks - The MCLR will affect the margins of banks. They will also have to publish their interest rates every month for at least 5 different tenures. They are also restricted in terms of the spread they can charge a customer during the loan term.

    Exemptions under MCLR

    • MCLR will be applicable to almost all loans except fixed rate home loans, car loans and personal loans.
    • Loans that fall under Government Schemes where the banks are directed to charge a certain rate of interest are also exempt from MCLR.
    • MCLR is applicable only to banks. So loans that are taken from finance companies and houses will not fall under this system. The Non-Banking Financial companies include LIC Housing Finance, Dewan Housing (DHFL), HDFC, Indiabulls etc.

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