03/01/2017
MCLR(Marginal Cost of funds based Lending Rate)
Let us first understand as to how banks make money or profit. The primary function of a bank 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 base rate system are;
Cost of funds (interest rates offered by banks on deposits)
Operating expenses to run the bank.
Minimum Rate of return ie margin or profit
Cost of maintaining CRR (Cash Reserve Ratio).
As you can see, the banks do not consider ‘repo rate’ in their calculations. They primarily depend on the composition of CASA (Current accounts & Savings Accounts) and deposits to calculate the lending rate. Most of the banks are currently following average cost of fund calculation. So, any cut or increase in rates (especially key rate like Repo Rate) by the RBI is not getting transmitted to the bank customers immediately.
(What is repo rate? – When we need money, we take loans from banks. And banks charge certain interest rate on these loans. This is called as cost of credit (the rate at which we borrow the money)
Similarly, when banks need money they approach RBI. The rate at which banks borrow money from the RBI by selling their surplus government securities to the central bank (RBI) is known as “Repo Rate.”)
As per the RBI’s new guidelines, it is mandatory for the banks to consider the repo rate while calculating MCLR with effective from 1st April, 2016. The new method — Marginal Cost of funds based Lending Rate (MCLR) will replace the present base rate system.
The main components of MCLR calculation are;
Operating Expenses
Cost of maintaining CRR
Marginal Cost of funds
After considering interest rates offered on savings / current / term deposit accounts.
Based on cost of borrowings i.e., short term borrowing rate which is repo rate & also on long-term borrowing rates.
Return on Net-worth
Tenor Premium (an additional slab of interest over the base rate, based on the loan tenure & commitments).
The main differences between the two calculations are i) marginal cost of funds & ii) tenor premium. The marginal cost of funds will have high weightage while calculating MCLR. So, any change in key rates (increase or decrease) like repo rate brings changes in marginal cost of funds and hence the MCLR should also be changed by the banks immediately.
(In economics sense, marginal means the additional or changed situation. While calculating the lending rate, banks have to consider the changed cost conditions or the marginal cost conditions.)
RBI’s key guidelines on MCLR
All loans sanctioned and credit limits renewed w.e.f April 1, 2016 will be priced based on the Marginal Cost of Funds based Lending Rate.
MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to more efficiently price loans at different tenors based on different MCLRs, according to their funding composition and strategies.
Banks have to review and publish their MCLR of different maturities every month on a pre-announced date.
The final lending rates offered by the banks will be based on by adding the ‘spread’ to the MCLR rate.
Banks may specify interest reset dates on their floating rate loans. They will have 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 periodicity of reset can be one year or lower.
The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date (irrespective of changes in the benchmark rates during the interim period). For example, if the bank has given you a one-year reset period in your loan agreement, and your base rate at the beginning of the year is say 10%, even if the interest rate comes to 9% in the middle of the year, you will continue at 10% till the reset date. Same will be the case even if the interest rate increases above 10%.
Existing borrowers with loans linked to Base Rate can continue with base rate system till repayment of loan (maturity). An option to switch to new MCLR system will also be provided to the existing borrowers.
Once a borrower of loan opts for MCLR, switching back to base rate system is not 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 are not allowed to lend below MCLR, except for few categories like loans against deposits, loans to bank’s own employees.
Fixed Rate home loans, personal loans, auto loans etc., will not be linked to MCLR.
How MCLR Works? (Example)
For instance, for salaried individuals, ICICI Bank has set a floating rate home loan at one-year MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will be 9.45% (9.20% +0.25%). This interest rate is valid till 30th April, 2016 (as given in the bank’s website). ICICI Bank has decided to set one-year MCLR as the benchmark rate for their home loans.
Though the MCLR is reviewed monthly, your home loan will be reset every year automatically, depending on the agreement with the bank.
So, if you take a Rs.50-lakh home loan on 10th April,2016, your home loan interest rate would be 9.45% . You have to pay EMI installments at this rate of interest for the next 12 months.
Let’s say one-year MCLR gets revised to 9.% in April, 2017 and the spread remains the same then your home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread of 25 bps).
How to Switch from Base Rate to MCLR?
This primarily involves two steps;
If you would like to switch to MCLR system then you have to request your banker to link your loan rate with MCLR instead of Base Rate.
Once your loan is linked with new MCLR rate, you can request your banker to reduce the quantum of ‘spread’. Your Banker may charge you one-time fee (conversion fee) for reduction in Spread. Henceforth, you will get the new Rate of Interest (ROI) which is linked with MCLR.
Opinion
If interest rate cycle is in a downward trend, MCLR can be beneficial to borrowers of loans like home loan buyers.
But do remember that the interest rates may not remain low forever, when the trend changes the MCLR rate hike can be swift.
If you are an existing home loan buyer and planning to repay your home loan in say next few years, you can consider switching to MCLR method (as of now the charges applicable to move to MCLR is not available, you have to account for these charges and then take final decision).
If you are planning to buy a property through a home loan, you may take the loan under existing base rate before 31st Mar, 2016. Based on the prevailing economic factors, the RBI may not cut interest rates in the very near future, you may continue with base rate and anyways you have the option to move to MCLR at a later point of time, if RBI cuts rates.
It is too early to say if the change in base rate will actually be completely passed on to consumers. Because, do remember that banks 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 you is 10.25% and the new base rate as per MCLR is say 10%, 0.25% is the spread)
As far as banks are concerned, their margins might take a hit in the range of Rs 15,000 to Rs 22,000 crore assuming a 75 basis point decline (source – ICRA). Banks may lose when interest rates drop but will gain when rates increase. So, it all depends on how many instances of ‘rate cuts’ will happen in the future.
MCLR is applicable for Banks only. Hence this is irrelevant to home loans offered by NBFCs (Non-Banking Financial Companies) like LIC Housing Finance, Dewan Housing (DHFL), HDFC, Indiabulls etc.,
