What is the MCLR Rate? How does it affect a Loan?

Highlight: Find what the MCLR rate is and how it can impact various loans. Know how MCLR impacts your best personal loans if they show changes in interest rates.

The MCLR or the Marginal Cost of Funds based Lending Rate system owes its introduction to the RBI or the Reserve Bank of India.  Launched in April 2016, this new MCLR rate lending system is a modified version of the old regime for base rates. Here, the new interest rates are calculated based on the repo rate and the bank’s interest rate on customer deposits. With the new rules in place, commercial banks are now obliged to set up new benchmarks for internal rates for lending based on the marginal cost of funds.

Need for MCLR

With the old base rate system for banks, whenever there were changes in repo rate, the banks were reluctant to align their interest rate promptly as per the change. Therefore, though RBI introduced rate changes periodically, banks were not keen enough to change their own lending or deposit rates.

With the introduction of the MCLR, the banks have to adjust their interest rates as per their risk factor for various customer segments. There are different benchmark rates for different loan tenures. So, first, the banks set rates for terms starting from 1 day or one month to 1 year. Based on them, the banks can also charge interest rates for more than one year.

Also Read: How Repo Rates Affects Interest Rates

What do you mean by the MCLR Rate?

The Marginal Cost of Funds Lending Rate is the minimum rate for lending below which a bank cannot lend or issue a loan. Here ‘marginal’ means additional or a change or margin in the current state, economic sense. The MCLR rate is thus based on any changes in the banks’ marginal cost conditions.

The MCLR is revised monthly based on the repo and other borrowing rates. Banks generally cannot lend below the MCLR, except in a few exceptional conditions.

In the following conditions, banks can lend below the MCLR:

• For loans against deposits 
• Loans to bank employees of the respective bank

Type of MCLR-linked Loans

With the latest RBI guidelines, all floating-rate loans sanctioned after 01.04.2016 will follow the MCLR, including their credit renewal. Existing borrowers with floating-rate loans can also switch to the MCLR rate as per the options given. These floating-rate loans include home loans, corporate term loans and loans against property.

MCLR is related to banks so any floating interest rate loan sanctioned by them will be linked to the MCLR. Some banks link their educational loans and auto loans with the MCLR. So, if you have a floating interest rate for your best personal or car loan, it will also be connected to MCLR.

Also Read: Floating Interest Rates vs Fixed Income Rates

Does MCLR impact personal loans?

Personal loans are a good option for short-term liquidity. It is important to note that the MCLR will not affect your best personal loans with a fixed interest rate. The variable rate of your best personal loans will become more affordable in the long run with lower EMIs.

Components of MCLR Rate

The MCLR rate is composed of different components. They are as follows:

• The marginal cost of funds that includes return on net worth and the marginal cost of borrowings
• Operating costs incurred by the banks
• Negative carry due to cash repo rate. All banks have to pay a cost to keep their reserves with RBI, which constitutes this carry.
• Tenor premium or the risk premiums charged by banks for long-tenure loans.

The banks charge the marginal costs as per the new guidelines set by the RBI based on these factors:

• Savings, current, term, and foreign currency deposits interest rates.
• Borrowings that include the short-term and long-term interest rate, and the repo rate
• Return on net worth

The marginal cost of funds, repo rate, and deposit rates determine 92% of the MCLR, while the return on net worth comprises the remaining 8%.

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Impact of MCLR Rate on Loans by Banks

The various loans offered by banks will have the following impacts given the MCLR.

• Regulated Interest Rates – With the old base rate lending system, the banks were quick to increase interest rates on floating-rate loans whenever there was an increase in rates, as announced by the RBI. However, when the RBI cut down the interest rates, they did not slash the rates with the same promptness. This resulted in a discrepancy in the interest rates. With the introduction of the MCLR rate, banks need to regularly change their rates as per changes in marginal cost conditions.
• Impact on the spread – Before introducing the MCLR, banks charged low spreads for low-interest rate loans. This would initially attract many customers, but later, banks unreasonably increased the space without valid reasons. This resulted in increased interest rates for the customer, as there was an increased spread even if the base rate was not increased.
  With the MCLR system, banks are mandated to fix a spread while sanctioning the loan. This spread will not be subject to increase until there is a change in the customer’s credit profile. Also, banks are required to reset their loan interest rates at least annually.

• Transparent Loan Pricing – The MCLR system has proved to be more transparent from the customer’s point of view with a special price of floating-rate loans. The banks are now required to set the spread when sanctioning the loan without unreasonable increases during the loan tenure.
• Bank Margins – The MCLR rate brings about a more fair and transparent system for interest rates and loan pricing in the case of variable interest rate loans. RBI requires banks to publish their lending rates every month for a minimum of five different tenures. This has to be followed strictly by all banks. Banks can now not increase the spread they charge customers during loan tenures.

Exemptions for MCLR Loans

MCLR rate arrangement is only applicable to banks. It does not apply to loans taken from Non-Banking Financial companies and other financial institutions or NBFCs like HDFC, LIC Housing Finance, DHFL, Indiabulls, etc.

Banks need to apply the MCLR system for all loans except car loans, fixed-rate home loans and personal loans with fixed interest rates.

Loans given by banks under the Central Government or State Government schemes are also exempt from MCLR, where the banks charge a specified interest rate as per government directives.

Conclusion

As applicable, banks cannot charge their lending rate below the MCLR rate for any loan maturities. However, most secure loans, Government of India special loan schemes, loans to bank employees and fixed-rate loans for more than three years are exempted from MCLR.