MCLR or marginal cost of funds-based lending rate is a benchmark interest rate, which is the minimum rate at which banks are allowed to lend. MCLR came into force in 2016, essentially replacing the base rate system, which was in force up until then.
MCLR rates were first introduced by the Reserve Bank of India (RBI) to ensure better pricing of floating rate loans by banks to end customers. Its main objective was to maintain a balance between the transmission of interest rate benefits from the monetary policy of RBI to borrowers on one hand and the interests of the banking system through a benchmark rate that can ensure profitability on the other.
Another fact to understand is that MCLR is an “internal benchmark” for a bank and it is linked to tenor, i.e., the amount of time left to repay a particular loan. It is currently being used by commercial banks as the lending rate for some of their loans and is set by each bank individually.
What Is MCLR and Why Was the MCLR Regime Implemented?
MCLR is aimed at creating a win-win situation for the lender and borrower by bringing improved transparency into the process of lending.
For example, in earlier days, there was no compulsion for banks to lower their interest rate as soon as the RBI rolled out a rate cut in its regular policy meetings. On the other hand, whenever the RBI increased policy rates, the general complaint was that lenders were quick to up their rates. This delay in transmission of interest rate cuts from the RBI to the borrowers has persisted even with the base rate system, which was introduced in 2010.
MCLR allows the revisions in interest rates done by RBI to be transmitted comparatively quickly to the borrower, with monthly updates to the MCLR. In other words, it helps borrowers benefit from RBI’s rate cut within a relatively shorter time frame.
In addition to quick transmission, greater transparency was also an objective to bring MCLR. In the earlier base rate system, a bank would charge customers a “spread” over the base rate depending on various factors such as loan category, customer type etc., the determination of which was not very uniform or scientific.
For instance, a bank with a base rate of 9% would charge customer A a rate of 9.5% (base rate + 0.5% spread) while customer B would be charged 9.75% (base rate + 0.75%). With the MCLR, the spread is prescribed to be fixed based on the riskiness of the customer and the tenor of the loan, with changes permitted only as per the sanction document and material changes in the risk profile of the borrower.
MCLR Versus the Base Rate
The RBI introduced MCLR as an alternative to the base rate system. In terms of the broader objective, both the base rate and MCLR set out to achieve the same thing – they enforced the minimum interest rate below which financial institutions cannot lend.
The two systems are also different in many ways, but the main point to remember is: MCLR and the base rate are similar in that they both are connected to the cost of borrowing for the bank.
Tenor and Marginal
The difference, however, is that MCLR adjusts for factors that determine the cost of funds for the bank, by considering the incremental cost of funds rather than the overall average cost of funds and the tenor of the loan, which has a bearing on the risk associated. The basic idea behind the MCLR regime is to provide banks with a uniform benchmark lending rate for different tenors that can be reset every month.
Before MCLR, banks were using several methods to calculate the base rate and the uniformity was missing. Hence, the base rate system (which is linked to a bank’s cost of funds) was not succeeding in achieving the goal of transparency. This is because banks often claimed that despite policy cuts by the RBI, their cost of funds has not reduced, and hence they were unable to roll out the revised interest rates to borrowers. And these benchmarks varied from bank to bank and from time to time.
With MCLR, RBI has standardized the benchmark rates across all tenors and hence has provided a uniform interest rate structure, which will help better the credit pricing process. Thus, the odds are not completely stacked against the borrower who enjoys more certainty and transparency.
How To Find a Bank’s MCLR
As mentioned before, MCLR is tenor-linked. So each bank determines its rates internally based on how much time is left to repay the loan. In simple words, there is an incremental cost associated with every rupee a bank arranges for its borrowers; this ultimately determines the rate of interest.
Basically, MCLR takes into account the following parameters:
- Tenor premium
As the tenure or period of loan repayment increases, so does the risk associated with it. This is because the lender has lesser visibility into the distant future prospects of the borrower than the immediate future. Hence, to reflect this higher risk, banks charge a higher interest rate to mitigate the risk of losses. This is called the tenor premium.
- Marginal Cost of Funds
This is a critical part of MCLR, as the name implies. This is how much it costs the bank to arrange the funds which it will, in turn, lend to a borrower and make a profit. The marginal cost consists of two parts – the marginal cost of borrowing (92% weightage), and the return on net worth (8%). The marginal cost of funds is the average rate at which the bank raised deposits of similar tenor in the specified period from its customers. The 8% return on net worth denotes the capital that the bank has to set aside as safety for lending – technically known as Tier-1 capital.
- Negative Carry on CRR
Banks are mandated to keep a portion of their funds as cash with the RBI, which earns no interest, known as the cash reserve ratio or the CRR. This component of the MCLR formula adjusts for the fact that a portion of the bank funds do not earn income.
- Operating cost
Banks incur various costs and overheads to maintain their day-to-day operations including rent, salaries, etc. This head covers these expenses, except for specific loan-related expenses like security creation for which service charges are recovered separately from the borrowers. Banks with more efficient operations can have lesser costs, which in turn leads to lower MCLR for customers.
Key Points Borrowers Need to Know About MCLR
- In the present day, if you are taking a bank loan charged on a floating interest rate, it will most likely be associated with MCLR or the more recent external benchmark linked system.
- MCLR is applicable only to banks offering floating rates of interest on their loan portfolios. These used to include all kinds of loans like home loans, property loans, some educational loans, auto loans, and corporate loans. But effective October 1, 2019, the RBI has put in force the mandatory external benchmarking system for retail and MSME loans, while keeping it optional for corporate and other loan types.
- This is a further improvement over MCLR in terms of promoting transparency.
- As MCLR impacts loans that are borrowed at floating interest rates, fixed interest is not affected by MCLR in any way. But in the case of hybrid loans, where the interest rates are partly fixed and partly floating, MCLR can apply to the floating part, subject to several criteria.
- Borrowers can find out their bank’s MCLR by visiting its website.
- As per regulations, banks should publish their minimum loan rate or MCLR within predefined timelines and these are to be revised each month depending on changes to the repo rate and other factors. They should fix their interest rates for tenures up to one year, for at least five loan tenures. Banks that lend below MCLR without due authorization from the RBI are likely to face strict disciplinary action.
- Repo rate has a direct effect on MCLR-based loans. As the RBI’s repo rate affects the cost of funds for the bank, the MCLR formula results in a reduction in interest rates to the borrower from the next cycle.
- Even if your existing loan is pegged to the base rate system, you still have the option to convert to MCLR. Existing borrowers can formally request their banks to shift their loan to MCLR while negotiating the spread to be kept to a minimum.
- Some banks may charge a conversion fee to borrowers who are on a base rate system if they opt to switch to MCLR-based loans. This could be up to 2% of the sanctioned loan. A few banks don’t charge their customers at all for the switch.
- Once a borrower has switched to the MCLR system, he or she cannot switch back to the base rate system. They can however switch to the external benchmarking system, provided it is applicable to their loan category.
- At present, MCLR-linked loans are proving to be of lower interest rates than the base rate loans. But this is not a given. Borrowers considering the switch to MCLR should be wary of the fact that if the RBI hikes interest rates, their interest rates too will increase in the future, just like it is with base rate loans.
Bottom Line
The basic motive of MCLR is to ensure that banks price loans to their borrowers fairly, taking into account actual market realities rather than opaque internal calculations. It clearly has many advantages. However, the clamor about MCLR has always been that while it was better than the base rate system, it still did not keep track of external benchmark rates, which meant that commercial banks were charging higher interest rates than what was required for good credit growth in India’s fast-growing economy.
With the introduction of the external benchmark lending rates (EBLR) in 2019, this has changed. As the name suggests, EBLR is an external benchmark that lenders can now use to price their loans. In line with the saying that the market knows the best, interest rates are now required to be pegged to market rates. What are market rates? As per the RBI, this could be the RBI’s repo rate, or rates such as Treasury Bill rates (at which the Government of India raises funds for its needs) which are announced periodically by Financial Benchmarks India Pvt. Ltd. (FBIL), an institution appointed by the RBI.
Banks are also advised to reset their interest rates once every three months at least. As compared to the internal benchmarks, like MCLR, borrowers will be able to see rapid changes in interest rates linked to external benchmarks taking transmission and transparency to the next level.
