MCLR: Marginal Cost Of Funds-Based Lending Rate

MCLR: Marginal Cost Of Funds-Based Lending Rate, This blog is all about marginal cost of funds-based lending rate (MCLR), which serves as a benchmark for banks to set their interest rates.

This MCLR is objective to offer borrowers with a higher level of transparency and cost effectiveness. The banking system regularly and at intervals is introducing various rate-setting methodologies that will be set and calculated on the basis of interest rates. In the April of year 2016 with the same objective, the Reserve Bank of India (RBI) introduced the MCLR rate regime.

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What Is MCLR Full Form?

MCLR is an abbreviation for marginal cost of funds-based lending rate and since April 1, 2016, the MCLR has acted as the internal benchmark rate of banks for extending all kinds of loans, including home loans.

In 2019, the RBI replaced MCLR rate regime with the repo rate regime as it fails to meet its key objective of offering transparency and cost effectiveness to the end-user. Although the home loans taken to buy a home in the period between April 1, 2016 and September 30, 2019, are still linked with the MCLR rate, it makes sense for borrowers to have a clearer understanding about the MCLR regime and decide if they want to switch their home loans to the repo rate regime.

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What Is The Meaning of MCLR?

Whenever a borrower take a loan and wish to extend it then on that the respective bank will charge an interest rate. It could be home loan, loan against property, gold loans, etc. As per the rules under banking regulations and approval of RBI, they have to set the interest rate, based on a rate-setting benchmark.

The banks according to rules are not only had to offer transparency in rate setting, they also have to quickly pass on the benefits of rate cuts, effectuated by the RBI, to the end-users, i.e., loan borrowers.

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RBI replaced the base rate regime with the MCLR rate regime, as it felt that banks were failing to meet these two objectives, because they used internal lending benchmarks in setting interest rates. MCLR was introduced to make sure banks were quick in passing on the benefits of interest rate cuts to the borrowers. And it was surely not happening in under the BPLR regime.

The internal lending benchmarks includes base rate and BPLR regimes thus making banks control it completely and invariably. And they failed to pass on the benefits that they themselves enjoyed when the RBI reduced the repo rate and offered them funds at a lower interest.

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The MCLR rate regime replaced the previous base rate system, which was operational since 2010. Earlier to this, banks lent to customers using the Benchmark Prime Lending Rate (BPLR) system.

MCLR is the rate below which banks will not lend funds to a borrower and it is based on various factors, like credit risk and tenure of the loan, they tweak the ‘spread’ between the MCLR and the actual interest rate. This means that the actual interest rates for loans will be determined by adding the component of spread to the MCLR rate.

To understand, we can assume bank’s MCLR rate is 6%, and then it can charge an 8% interest from the borrower, by keeping the spread at 2%.

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What Are The Components Of MCLR Rate Regime?

The MCLR rate regime, which is closely linked to the actual deposit rates, is built on four key components:

Marginal cost of funds or MCF: The marginal cost of funds is the average rate at which the deposits with similar maturities were raised during a specific period before the review date.

Negative carry on account of cash reserve ratio (CRR).

Tenure premium: The cost of lending varies depending on the period of the loan.

Operating costs: It is the cost of raising funds.

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How to Reset MCLR Rates?

Under the MCLR regime, banks reset the MCLR rates at periodic intervals – overnight, one month, three months, six months and one year.

When we talk about home loans, the MCLR is typically based on a one-year MCLR rate. This means that even if the RBI reduced the repo rate thrice in a year, the bank will change the MCLR rate only once in a year.

With MCLR, banks were required to readjust the rate of interest monthly or yearly, depending on this resetting clause in your loan document. Financial institutions are mandated to review and publish MCLR of different maturities on a monthly basis.

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MCLR Rate And Fixed-Rate Loans

To determine the interest rate the fixed rate loans are exempted from being linked to the MCLR benchmark. The MCLR rate is applicable only on floating rate loans. However, fixed-rate loans with tenors of up to three years are also priced according to the MCLR rate.

Kind Of Loans Are Linked With MCLR

Under the MCLR rate regime, banks can offer all categories of loans at floating interest rates. Several types of loans used to be linked with the MCLR benchmark, including home loans.

What Is The Difference Between MCLR Rate And Base Rate?

Base rate and MCLR rate were both internal lending benchmarks but they were different from each other in the way they treated the calculation of marginal cost.

As in the base rate system, the marginal cost used to be calculated by taking a simple average of the interest rates spent on deposits. However, under the MCLR rate regime, interest rates were calculated according to the marginal calculation of the cost that the bank incurred, to arrange the deposits. Unlike the base rate system, the RBI-determined repo rate is included in the marginal cost in the MCLR regime. Another difference between base rate and the MCLR rate is that unlike base rates, MCLR rates are revised every month, too.

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What Are The Exemptions Under MCLR Regime?

The MCLR regime was applicable on all loans, barring car loans and personal loans. Loans that fall under government schemes, where the banks were directed to charge a certain rate of interest, were also exempt from the MCLR rate regime. The MCLR regime was applicable only on banks and not on housing finance companies (HFCs) or non-banking finance companies (NBFCs). So, between 2016 and 2019, HFCs and NBFCs used their own internal lending benchmark to lend loans and not the MCLR.

Why did MCLR Regime fail?

The MCLR is a tenor-linked internal benchmark and this was the major reason for its failure. This means, the interest rate is decided internally by the lender, depending on the period left for the repayment of a loan. Even though banks had to take into account the changes in the repo rate, while calculating the MCLR rate, they failed to pass on the benefits of the RBI’s rate cuts, under the MCLR rate regime. This was a similar problem under the base rate and the BPLR regime.

Also, because of the ambiguities in the reset clause, borrowers found the MCLR rate regime confusing and complicated.

In the case of home loans, banks invariably kept a one-year reset clause that means once a year only it will be changed. This meant that even if the RBI lowered its repo rates multiple times in a year, the borrower’s EMI would go down only after the bank re-adjusted it, as mentioned in the agreement.

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