Reserve Bank of India (RBI) has asked all banks and NBFCs to move to MCLR (Marginal Cost of Fund Based Lending Rate) based interest rate instead of base rate which was followed before. All new loans on or after April 1st, 2016 will be sanctioned based on MCLR rates.

MCLR stands for Marginal Cost-based Lending Rates. The loans before were based on base rate plus spread. Spread is nothing, but the risk factor and loan tenor associated with any loan applicant. If the base rate of a lender is 9.40% and the spread is 60 bps, then the interest for the applicant will be 10%.

In this article we will answer questions pertaining to MCLR.

Need for MCLR

During 2014 – 2016 RBI reduced the interest rates multiple times, but the home loan interest rates did not go down quickly. Banks were reluctant to reduce the lending rates and transfer the rate cuts they received to the customer.

Before MCLR was introduced all loans were based on Base rate plus spread. The Base rate was common for all loans and the spread was fixed throughout the term of the loan. When RBI cut the lending rates, banks gave the excuse that if they reduce the new loan rates then the existing rates also need to be reduced. Even though the cost of loans is reduced now, the rate of fixed deposits, savings accounts etc. of already existing accounts are still high.

RBI could not do anything to get the change in interest rates reach the consumer quickly. This gave rise to MCLR.

With MCLR banks link their lending rates to marginal funding costs (cost of fresh or incremental borrowings). If a bank reduces the fixed deposit rates, savings account balances etc. then it must transfer the cut in deposit rates to the lending rates. This way if you bring down borrowing rates then you will need to reduce lending rates.

Is MCLR advantageous?

For new loan borrowers MCLR is advantageous as the rate of interest will be lesser than base rates. With changes in interest cycles which will happen at different MCLRs namely overnight, 1-month, 3-month, 6-month, 1-year or more (in case of longer tenors) could further reduce the interest rates.

The loan will have clause stating the interest reset period stipulated by each bank for example it is 6 months for Kotak Mahindra and 1 year for ICICI bank. This means that any change that occurs in the interest will be reset only after the stipulated reset time.

Should I move to MCLR from base rate?

It depends on the cost of transferring the loan and the benefits in numbers. For example, if Sanjay takes a home loan of Rs.30,00,000 at a base rate of 10% per annum for a tenor of 20 years. Now the interest for the loan will come to Rs.39,48,156 and overall amount payable is Rs.69,48,156 with monthly EMI of Rs. 28,951.65.

Sanjay has paid the loan for 3 years which amounts to Rs.1042259.40, and by following base rate the balance payable will be Rs.59,05,896.60.

In this 3 years Sanjay would have paid Rs.10,21,767.21 in interests with the balance in principle being Rs.29,79,154.82. if for this new principle Sanjay pays MCLR rate of 8.55% for the rest of the tenor of 17 years he will pay Rs.56,60,184, where he saves Rs.2,45,712.60.

There is also the case where if the change in your bank from base rate to MCLR does not give any reduction in interest paid, you can also opt to transfer the loan to another bank which does. But you need to be careful as when doing balance transfer it will involve foreclosure penalty charges with your existing bank and processing fee with new bank. Even with these costs if you still end up paying less interest then you can move to that bank.