One of the recent euphorias from many of us is about MCLR and its impact on our EMI. Whether I should switch from the existing loan to MCLR based loans? There is a lot of confusion as the concept is new and common people can’t understand the terms used. Hence, let us simplify and understand this concept.
All loans sanctioned and credit limits renewed w.e.f 1st April 2016 will be priced based on the Marginal Cost of Funds based Lending Rate (MCLR).
All the existing borrowers with loans linked to Base Rate can continue with base rate system till repayment of the loan. An option to switch to new MCLR system will also be provided to the existing borrowers. However, once a borrower of loan opts for MCLR, switching back to base rate system is not allowed.
Loans covered by government schemes, where banks have to charge interest rates as per the scheme are exempted from being linked to MCLR.
Before proceeding further, you must first understand the meaning of below two definitions which economist use.
What is the meaning of Repo Rate?
Let us say you need money and you don’t have that much money with you. Then what you will do? You approach the lenders right (Banks)? Banks usually charge some interest on this. Such interest is the COST you have to pay to bank by using their money. Such cost is called as “Cost of Credit”.
Same way, banks, when they need money, will approach the central banker (in India it is RBI). Therefore, RBI has to charge something for such lending to banks. This lending rate from RBI to banks is nothing but Repo Rate. RBI fix this rate. The repo rate is used to control the inflation. Do remember one thing that excess money in the economy means more inflation. Because when the money is available easily for all of us then we spend more. This leads to more demand for the same goods leading to higher inflation.
Let us assume how the repo rate is used to control the inflation.
# RBI increases the Repo Rate–
To control the excess money supply and inflation, RBI increases repo rate. This leads to the costly borrowing for all banks. What banks do? They transfer this cost to customers in terms of loans. When loan rates go up, then only few will approach for a loan. This will turn to less money with people leading to cash shortage in the economy.
When you have no money, then your spending will also be reduced. So when spending reduced, then no one will buy the goods and services. Leading to lower inflation.
# RBI decreases repo rate–
If there is low inflation or less demand, then to manage this situation under control, RBI may decrease the Repo Rate. This leads to the cost of money borrowing by the bank as less costly. Banks in return reduce their loans. Loans at a lower level mean more people will flock at borrowing. This infuses more money in the economy. More spending generates the high inflation.
Do remember that both HIGHER inflation or LOWER inflation are bad for the economy. Hence, to control inflation RBI use this tool along with some other tools.
I found this Quora answer the best example to illustrate how the inflation and rate of interest control mechanism work in the economy.
From above points, it is to be noted that the INTEREST RATE at which you take loans will not be constant. It used to be change based on the economy.
What is the meaning of Cash Reserve Ratio or CRR?
It is some % of the total amount of cash banks accumulated through deposits, which banks have to deposit with RBI. The main purpose of keeping the money with Reserve Bank is that banks do not run out of cash to meet the payment demands of their depositors.
Therefore, this is nothing but the BLOCKED money which they have to keep with RBI as a safety and statutory measure. RBI will not give any interest on such deposited cash. This is simply an IDLE money which banks have to keep with RBI as a safety measure.
RBI changes this ratio as per the economic condition. If RBI feels that more money is required in the economy, then it reduces the CRR and same way reverse may also be possible.
What is the Base Rate of Lending and how it used to be calculated?
From above information, you come to know that interest rate is not stagnant forever. It is dynamic in nature. Now let us move further.
Before the implementation of MCLR rate, there was the system to arrive at the interest rate for loans. This rate of the system is called Base Rate. Now, all loans are MCLR based (except few). Hence, it is must for you to understand what is base rate system and why RBI moved to MCLR than this base rate system.
The base rate is the lending rate of banks below which Banks were not allowed to lend. Let us say SBI’s base rate is at 8%, then they never have to lend the money below the 8%. Along with base rate, there is something called as a spread. Spread is the rate of interest which is over and above the base rate.
If the base rate of the bank is 8% and spread is 0.5%, then you will get the interest on the loan at 8.5%. Hence, your loan rate is nothing but Base Rate+Spread.
This spread depends on many things and depending on the risk profile of the customer and the tenure of the loan banks used to fix it.
Before the implementation of MCLR based loans, banks used to follow the Base Rate type system to arrive at the interest rate of loans. During the falling interest rate, banks used to respond very lately. Means let us say RBI reduced the interest rate by 1%, then banks never used to reduce it or they may do so after few months.
Hence, even though RBI reduced the interest rate, you still may be paying higher interest on your loans. The reasons for this delayed action by banks is known to all and reasons are as below.
Let us understand how this Base Rate system used to be calculated. To arrive at the Base Rate system, banks have to consider the below four important points.
- The cost of Funds-Banks needs to accumulate the cash to give it to you as loan right? From where they get this cash? From the depositors (there are many ways banks can accumulate the cash, but I am trying to simplify this for better understanding) they get this cash. To get this cash, banks have to give an interest on such deposit to the depositor. Such costs of accumulating the cash are nothing but Cost of Funds.
- Operating Expenses-Along with the above said expenses, banks have to incur some expenses to manage the loan, deposits or managing the banks. Such operating expenses are also considered as the part of base rate.
- Cash Reserve Ratio-As I already explained above, this is nothing but a safety money banks have to deposit with RBI. As this CRR will not fetch any return to banks, banks include this as criteria while calculating the Base Rate.
- Margin-The above said all three points are expenses which banks have to incur. But banks have to run the business. So they need profit more than what they spend. Hence, they put some margin also.
Based on the above four criteria Base Rate System was used to calculate.
The drawback of Base Rate System of Loans-
The biggest drawback of Base Rate System was consideration of “Cost of Funds”. Let us assume RBI changed the rate of interest by 1% on 1st April, 2017. Banks never tried to lower their lending rate immediately. Because as per them, the cost of funds is HIGHER than the current rate of interest. They used to claim that the FDs they booked are at a higher rate and hence their cost of funding is higher than the current RBI rate.
Hence, they never used to act swiftly whenever there is rate movement (especially the rate cut). This irked to us as a customer of the bank. Because banks for consideration of the cost of funds, not consider the current FD rates or deposit rates. Instead, they used to consider the older FD or Deposit rates.
Also, the calculation method of cost of fund is totally different with each individual banks (some use the average cost of funds method, some had adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method).
Due to all these mess up, banks used to react fastly when there is an increase in the rate of interest. However, they are slow in reacting or reducing the rate of interest on their loans when there is a decrease in interest rate by RBI.
Also, up to January 2015, there was no such rule that when banks should update their Base Rate. They may retain the same base rate for a year also. But after January 2015, RBI made it mandatory to review the Base Rate at least once in a quarter.
Obviously, such moves gave the bank to act quickly when the RBI increases the interest rate. However, they used to lethargy when RBI reduce the interest rate.
What is MCLR based loan?
Considering the above-said negativities of Base Rate System of lending, RBI introduced the MCLR based loans or Marginal Cost of funds based Lending Rate. The new system came into effect from 1st April 2016.
As I pointed above, earlier your loans interest was used to arrive at a spread over the Base Rate. For example, if the base rate was 8% and the spread was 0.5% for your risk profile and loan tenor, you will have to pay 8.5% on your loan. From April 1, 2016 MCLR will replace Base Rate. All the new loans will be offered at MCLR + Spread.
How is MCLR or Marginal Cost of Funds Based Lending Rate calculated?
MCLR is usually arrived at based on below mentioned four considerations.
1) Marginal Cost of Funds: This is the cost of CURRENT borrowing to the bank. You noticed in based rate system that banks used to arrive at the cost of the fund as per their comfort. Also, they used to consider the existing deposits rates as if the cost of fund. However, in the case of MCLR based loans, the last month deposit rates (current, savings, term deposits etc) will be considered to arrive the cost of funds.
Banks not only consider the current borrowing cost but also their margin of profit is also included in this Marginal Cost of Funds. This is called as the Return on Networth. The return on net worth is nothing but the bank’s profit they want to earn from their lending business.
You might be noticed that in the case of base rate system, the cost of fund and margin was used to calculate separately. However, in case of MCLR based loans, both cost of fund and margin (return on net worth) are together are called Marginal Cost of Funds.
The calculation of this Marginal Cost of Funds is as below.
Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%
Notice the above formula, the stress or the higher priority to arrive at Marginal Cost of Funds is to cost of borrowings (the deposits banks accepted) than the return on net worth or margin.
2) Negative Carry on Cash Reserve Ratio-
As I pointed above, banks have to keep a certain level of their deposits with reserve bank. This is the safety measure and banks will not earn any interest on this amount. Banks have to keep a certain level (4% as on April 5, 2016) of their deposits with the Reserve Bank. This ratio is the Cash Reserve Ratio (CRR). Banks don’t earn any interest on the amount. Essentially, they can use 96% of the deposits for lending and the remaining 4% does not earn the bank anything. RBI allows some leeway for this with adjustment to the
Hence, such cost is also considered to arrive at MCLR calculation.
3) Operating Costs-
Apart from the cost of deposit and CRR, banks also have to incur some expenses. Such expenses are called as Operating costs. Such cost may include the salaries, rent or other overhead expenses.
4) Tenor Premium/Discount- If the bank is lending for higher tensors (like home loans), then there are uncertainties associated which are not factored in the MCLR calculated based on (say) 1-year MCLR. Therefore, the banks will charge a premium to the borrower for the risk (uncertainty) associated with lending for higher tenor loans.
Hence, this tenor premium is usually higher for long tenure loans.
Considering all above four factors, Banks arrive at MCLR rate.
Types of MCLR based loans
RBI directed banks to set at least 5 MCLR rates like overnight, 1 month, 3 months, 6 months and 1 year. The banks can choose to have more (for longer tenors like 2 years or 3 years also).
Banks usually fixes which MCLR to be used for your loan. Usually, for home loans, it may be either 6 months or 1-year MCLR. Same way for personal loans it may be less than a year MCLR rate.
Once your loan tenure is decided then banks will link the type of tenure to your loan and arrive at the final interest rate applicable to you. It is as below.
Interest Rate=MCLR + Spread
MCLR rate will be reviewed and published on a monthly basis. All new loans during that particular month will be offered at that latest MCLR+SPREAD.
Take for an example of SBI Bank’s current MCLR Rate chart. It looks as below.
Now let us assume that you applied for a home loan in the month of May 2017. The loan amount is Rs.30 lakh and tenure of the loan is 20 years. Then bank may lend you for 1 Year MCLR+Spread of 0.35%. So the total interest rate applicable for you will be 8.10% (1 Year MCLR Rate)+0.35% (Spread)=8.45%.
One more important thing to notice that in above example if you took the loan which is linked to 1 year MCLR of 2017, then the next interest rate revision will be on May 2018.
In between if there are any changes to interest rate risk, your interest rate will not change as you are locked for a year with 1-year MCLR rate. Same applies to one month, three months, six months, two years or three years MCLR rated loans.
What is the meaning of Spread in MCLR?
There are two types of spreads. First one is business strategy spread and another is credit risk spread. Business strategy spread is something which banks have to decide based on the profitability and their survival. Credit risk spread is based on individual who approaches the bank for a loan or a based on type of a loan.
MCLR is nothing but the cost of the loan. But what about the risk involved in lending money? This will be charged based on your creditworthiness. The spread may depend on creditworthiness bank’s assessment of your repayment ability.
Usually, this spread will remain constant for you throughout the loan tenure. However, it may change in the middle when banks found the risk of lending you is high than the earlier. It is not easy to change this spread in the middle of the loan. Hence, you no need to worry about change.
Spread differs from banks to banks and also based on the types of loans and tenure. But you must make sure that your spread must be low. Let us take an example to point this.
Mr.A opted for a loan of Rs.30 lakh with 1 Year MCLR which is at 8% and spread at 0.5%. Also, Mr.B opted for a loan of same Rs.30 lakh with a 1 Year MCLR which is at 8.2% and spread at 0.3%.
For Mr.A the interest rate will be 1 Year MCLR 8%+Spread 0.5%=8.5%.
For Mr.B the interest rate will be 1 Year MCLR 8.2%+Spread 0.3%=8.5%.
In such a situation, who will be beneficial in long run? Obviously, the one who holds the lower spread.
Assume that after a year 1 Year MCLR for both changed to 8.5%, then Mr.A will have to pay the interest at 9% (8.5%+0.5%) and for Mr.B it is 8.8% (8.5%+0.3%).
So the spread plays a major role in identifying the interest rate. Do remember that banks are free to set their spread rate. Hence, even though they may not change the spread to existing customers, but for new customers, they may drop the MCLR rate but increase the spread.
At the end, they earn the same interest rate even though the rate has fallen deeply. Hence, you must concentrate both on MCLR and spread while going for a loan.
Difference between Base Rate Loans and MCLR loans
# Base rate loans interest rate will be updated once in a quarter. However, MCLR loans interest rate will be published on monthly basis.
# Cost of fund consideration for base rate loans calculation is not standard and banks consider the older cost on deposit to arrive at the cost of fund. However, in the case of MCLR loans, the cost of fund is the deposit rate applicable to for that particular month.
Hence, the MCLR loan calculation considers the current cost, which is not with base rate system.
# Base rate loans consider the Cost of Funds but MCLR considers the Marginal Cost of Funds to arrive at the rate.
# Base rate loans consider margin as a rate of return of business. Whereas such rate of return is included in Marginal Cost of Funds itself.
# Tenor Premium is added to MCLR as the frequency of change in the rate of interest is so short.
I tried to explain the same from below chart.
Can we shift to MCLR based loans?
There is a huge cry on this issue. Because those whose loans are on base rate system now feeling that MCLR rates are BEST. Because ththeseCLR rates are offering you the lower interest rate. But the reality is that NONE can judge like which is BEST for you.
But do remember that interest rate movement will fastly affect to your MCLR based loans. Hence, as of now the interest rate is on a downward trend. Therefore, you are feeling happy. But the same may dangerous when interest rate cycle starts to move up.
Even though MCLR based loans transfer the interest rate benefits fastly than the base rate system, banks still have an edge. They can compensate such downtrend by fixing the higher spread.
Hence, MCLR based loans do not mean the EIGHTH wonder of the world. Only the cost of funding and tenor premium are the added advantage. Also, the frequency of updating the rate change. But rest of the method is almost same and banks can play with the spread. Because there is no specific guidance set for fixing the spread.
Along with above-said factors, your switching will mainly depend on below points.
- Outstanding Principal
- Loan Tenure
- Interest Rate Difference between existing loan to new MCLR.
- Switching Fee
- Future interest rate movement
Finally, never heed to your bankers and suddenly never take a decision of shifting the loan from one bank to another bank or within a bank also. Check the MCLR Rate offered, Spread and the type of MCLR they are linking to your loan (like 6 months MCRL or 1 Year MCLR). Based on this you must take a call.
Also, as I pointed above, currently all customers are happy with MCLR as the interest rates are going down. However, once the situation reverse, then the impact of rate change will be with the same force as it is now. Hence, you must be ready for both.
If you still have confusion, then ask me by commenting to this post.