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What Is MCLR And How It Affects Bank Loan?

what is mcl and how it affects bank loans

MCLR and Bank Loan

Today, it has become very easy for a erson to buy a home, car, cell phones etc. because of the facility of bank loans. Maximum people apply for the bank loan when they buy their dream house. But it never ends there. Do you know anything about MCLR rates? How it affects your home loans or any loans which you have taken from your bank? What you should opt while taking a loan? 

In this article, I will clear all the questions related to MCLR. Read further to know it in detail:
What is MCLR?

The Marginal Cost of funds based Lending Rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend (give you the loan), except in some cases allowed by the RBI. It is an internal benchmark or reference rate for the bank. MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank - on the basis of marginal cost or the additional or incremental cost of arranging one more rupee to the prospective borrower.

As the need for bettering the lending rate system was rising, the MCLR methodology for fixing interest rates was introduced by the Reserve Bank of India with effect from April 1, 2016. This new methodology replaces the old base rate system introduced in July 2010.

How does a MCLR-linked loan work?

Under the MCLR scheme, loans works differently from the base rate regime. Two terms you should familiarise yourself with is “Reset Clause” and “Spread”.

Reset ClauseOn the day your loan is sanctioned, the MCLR prevailing on that day will be applicable on your loan. There will be reset dates allotted to your loan, and the interest rate will change to the MCLR prevailing on the reset date. The periodicity for a reset is usually 1 year or lesser depending on the agreement with the bank.

For example, your loan is sanctioned on April 1st with a reset period of 1 year. The prevailing MCLR on 1st April 2016 is 10% per annum. This will be your interest rate for 1 year. If the rate falls to 8% during the year, this will not affect your rates. Your loan will continue at the same 10% as it is valid for 1 full year. On 1st April 2017, the interest rate will change to the prevailing rate on that day.

Spread - The loans linked to MCLR comes with a spread. Banks can spread their MCLR over 25 basis points. The spread, in simple terms, means the amount or margin that you have to pay over the MCLR. Banks are free to set the range of spread on different loans.

For Example, if the MCLR is 11%. But the rate of interest offered by the bank is 11.25%. The difference is the spread imposed by the bank, i.e., 0.25%.

Reasons for introducing MCLR

RBI decided to shift from base rate to MCLR because the rates based on marginal cost of funds are more sensitive to changes in the policy rates. This is very essential for the effective implementation of monetary policy. Prior to MCLR system, different banks were following different methodology for calculation of base rate/minimum rate - that is either on the basis of average cost of funds or marginal cost of funds or blended cost of funds. 

Thus, MCLR aims:
  • To improve the transmission of policy rates into the lending rates of banks.
  • To bring transparency in the methodology followed by banks for determining interest rates on advances.
  • To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
  • To enable banks to become more competitive and enhance their long run value and contribution to economic growth.
Calculation of MCLR

The MCLR is a tenor linked internal benchmark (tenor means the amount of time left for the repayment of a loan). The actual lending rates are determined by adding the components of spread to the MCLR. Banks will review and publish their MCLR of different maturities, every month, on a pre-announced date.

The MCLR comprises of the following:

a) Marginal cost of funds which is a novel concept under the MCLR methodology comprises of Marginal cost of borrowings and return on networth, appropriately weighed. i.e.,

Marginal cost of funds = (92% x Marginal cost of borrowings) + (8% x Return on networth)

Thus, marginal cost of borrowings has a weightage of 92% while return on net worth has 8% weightage in the marginal cost of funds. Here, the weight given to return on networth is set equivalent to the 8% of risk weighted assets prescribed as Tier I capital for the bank. The marginal cost of borrowing refers to the average rates at which deposits of a similar maturity were raised in the specified period preceding the date of review, weighed by their outstanding balance in the bank’s books. i.e,

Rates offered on deposits of a similar maturity on the date of review/rates at which funds raised x Balance outstanding as a percentage of total funds (other than equity) as on any day, but not more than seven calendar days prior to the date from which the MCLR becomes effective.

b) Negative carry on account of Cash Reserve Ratio (CRR) - Negative carry on the mandatory CRR arises because the return on CRR balances is nil. Negative carry on mandatory Statutory Liquidity Ratio (SLR) balances may arise if the actual return thereon is less than the cost of funds.

c) Operating Cost associated with providing the loan product, including cost of raising funds, but excluding those costs which are separately recovered by way of service charges.

d) Tenor Premium- The change in tenor premium cannot be borrower specific or loan class specific. In other words, the tenor premium will be uniform for all types of loans for a given residual tenor.

Banks may publish every month the internal benchmark/MCLR for the following maturities:
  • Overnight MCLR,
  • One-month MCLR,
  • Three-month MCLR,
  • Six month MCLR,
  • One year MCLR.

MCLR for any other maturity which the bank considers fit.

Effects of MCLR

Regulation in Rate Changes - Under the old system of base rates, the RBI noticed the banks were prompt to increase interest rates on floating rate loans when the RBI increased rates. But on the other hand, when the RBI slashed rates, banks were slow to cut their rates. The aim of the MCLR system is to change this pattern and get banks to change their rates regularly according to the changes in cost conditions.

Effect on spreadThe RBI also noticed that banks would initially offer low interest rate loans at very low spreads. This would be appealing to the customer. But after a few months, the banks would increase the spread for no legitimate reason. Even if the base rate was not increased, the spread would be raised, therefore resulting in an unfair rise in interest rates for the customer. Under the MCLR, banks are required to set a spread chargeable to the customer at the time of sanctioning the loan. The spread cannot be increased unless the customer’s credit profile changes. Furthermore, banks have to reset the interest rates on loans at least once a year.

TransparencyOverall, the MCLR brings in more transparency for the customer. The pricing of floating rate loans will be clearer.

What kind of loans are linked to the MCLR?

All floating rate loans that were sanctioned from April 1st, 2016, are all based on the MCLR. For credit renewal as well, the MCLR was applied. Floating rate loans include:
  • Home loans
  • Loans against property
  • Corporate term loan
The MCLR is relevant only to banks. So any loan with a floating interest rate sanctioned from a bank will be linked to the MCLR. Some banks have also linked their auto loans and educational loans.

Base Rate vs MCLR

Base rate calculation is based on cost of funds, minimum rate of return, i.e margin or profit, operating expenses and cost of maintaining cash reserve ratio while the MCLR is based on marginal cost of funds, tenor premium, operating expenses and cost of maintaining cash reserve ratio. The main factor of difference is the calculation of marginal cost under MCLR. Marginal cost is charged on the basis of following factors - interest rate for various types of deposits, borrowings and return on net worth. Therefore MCLR is largely determined by marginal cost of funds and especially by deposit rates and repo rates.

Exemptions under MCLR

MCLR is applicable to almost all loans except fixed rate home loans, car loans and personal loans.

Loans that fall under Government Schemes where the banks are directed to charge a certain rate of interest are also exempt from MCLR.

MCLR is applicable only to banks. So loans that are taken from finance companies and houses will not fall under this system. The Non-Banking Financial companies include LIC Housing Finance, Dewan Housing (DHFL), HDFC, Indiabulls etc.

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