What is MCLR?
MCLR stands for Marginal Cost of Funds Lending Rate, It has been Introduced in April, 2016 and all the loans sanctioned after April 2016 are priced under MCLR. It was to ensure such that the changes in interest rate policy is effectively transmitted to the bank customers.
However policy transmission was not very effective as banks adopted various methods in calculating their cost of funds. At present, banks and banking institutions are slightly slow in changing their interest rate in accordance with Repo Rate change by the Reserve Bank of India.
We know that banks make money or profit. How?
The primary job of the bank/banking institution is to lend money and to accept deposits from the public. The difference between advances and deposits is the income earned by the banks.
So, how is the base rate or Standard Lending Rate calculated by the banks?
The main components of this ‘base rate system’ are:-
· Cost of funds .
· Operating expenses mandatory to make the bank function.
· Minimum Rate of return, be it margin or profit.
· Cost of maintaining the CRR (Cash Reserve Ratio).
As seen, the banks or banking institutions do not consider ‘repo rate’ in their calculations. They primarily depend on the composition of CASA , or the Current accounts & Savings Accounts, and deposits in order to calculate the lending rate. Most of the banks/banking institutions are currently following an average cost of fund calculation. So, any cut or increase in rates (especially key rate like Repo Rate) by the RBI will not get transmitted to the loan takers, immediately.
According to the RBI’s new guidelines, it is important for the banks to consider the repo rate while calculating MCLR. This has been effective since April earlier this year.
The consisting components of MCLR calculation are:-
1) Operating Expenses.
2) Cost of maintaining CRR.
3) Marginal Cost of funds.
These are made after considering interest rates offered on savings / current / term deposit accounts.
It is based on the cost of borrowings, short term borrowing rate which is repo rate and on on long-term borrowing as well. Home loans thus have the MCLR, too.
In terms of economics, ‘marginal’ indicates the additional or changed situation. While calculating the lending rate,banks/banking institutions have to consider the changed cost conditions , or the marginal cost conditions.
RBI has given some key guidelines on this concept.
All loans sanctioned from April 2016 are priced ,based upon the Marginal Cost of Funds based Lending Rate.
It is a tenor-based benchmark instead of a single rate. This thus allows banks to efficiently price loans at different tenors based on different MCLRs, as per their funding composition and strategies.
Banks must review and publish their MCLR of different maturities every month on a date announced from beforehand.
The final lending rates offered by the banks/banking institutions will finally be based upon on adding the ‘spread’ to the MCLR rate.
Banks/banking institutions have the right to specify interest reset dates on their floating rate loans. They can use the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
The period of the reset can be one year or less.
The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date.
Existing borrowers with loans linked to the base rate can continue with base rate system till repayment of loan maturity. An option to switch to the new MCLR system can also be given to the current loan takers.
Once a borrower of a (home) loan opts for MCLR, switching back to base rate system will not be allowed.
Loans covered by government schemes where banks have to charge interest rates as per the scheme are exempted from being linked to MCLR.
Like base rate, banks/banking institutions are not allowed to lend below it, except for a few categories such as loans against deposits, loans to bank’s own employees.
However our point of concern, fixed rate home loans will not be linked to MCLR.
Though, how does MCLR work?
Though it is reviewed monthly, one’s home loan will be reset every year automatically, depending upon the agreement with the bank/banking institution.
So, if one takes a Rs.50-lakh home loan, their home loan interest rate will approximately be a 9.45% . They should have to pay EMI installments at this rate of interest for the incoming 12 months.
Let us suppose the situation that one-year MCLR gets revised to 9.% in April, 2017 and the spread remains the same ,then, their home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread of 25 bps). Click here to read about Home loan by AXIS Bank.
How can one switch from base rate to MCLR?
If one wishes to switch to MCLR system then they must request their respective bank/banking institution employee to link their loan rate with MCLR instead of base rate.
Once the loan is linked with new MCLR rate, they can request their bank employee to reduce the quantum of ‘spread’. Their bank employee may charge a one-time fee (conversion fee) for reduction in Spread. Henceforth, they can and will be able to avail the new Rate of Interest (ROI) which is linked with MCLR.
If the interest rate cycle is in a downward trend, MCLR can be beneficial to borrowers of loans , especially to home loan borrowers.
But one should remember that the interest rates might not remain low forever, when the trend changes the MCLR rate hike/(s) can be swift.
If one is an existing home loan buyer and is planning to repay their home loan in the next few years, they could consider switching to MCLR method.
It , however is a bit too early to conclude that if the change in base rate will actually be completely passed on to consumers. Because, banks/banking institutions still have the option to set a ‘spread‘ on loans. Banks are free to determine the range of spread for a given category of borrower or type of loan. (For example, if the loan interest rate offered to the consumer is 10.25% and the new base rate as per MCLR is say 10%, 0.25% is the spread.)
Banks may incur a loss when interest rates drop ,but might gain when rates increase. So, it all depends on how many instances of ‘rate cuts’ might happen in the future.
MCLR is applicable for banks and banking institutions only. Hence, this is irrelevant to home loans offered by NBFCs (Non-Banking Financial Companies) such as LIC Housing Finance, Dewan Housing (DHFL), HDFC, Indiabulls and so on.
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