Banks may not be passing MCLR cuts to new Home Loan Borrowers

A reader of this blog, Pradeep, highlighted an important issue about MCLR recently. He pointed out that the a few banks are increasing the spread in order to compensate for the reduction in MCLR. By doing this, they are able to keep the lending rate constant (for the new borrowers) despite the MCLR going down.

I checked the home loan rates for male salaried borrower for ICICI Bank.  In July, the home loan was offered at 9.45% (9.2% + 0.25%). In August 2016, the home loan is still offered at 9.45% per annum but the breakup had changed. MCLR became 9.1% and the spread was 0.35%.

Do note this increase in spread in only for the new borrowers. Existing borrowers will continue at the contracted spread.

For the uninitiated, since April 1, 2016, home loans are being offered at MCLR + Spread. MCLR is linked to incremental cost of borrowing for the bank. Since the MCLR is mathematically derived, there is not much discretion in the hands of the bank. However, as Pradeep pointed out, the banks can easily tinker with the spread.

Must Read: All you need to know about MCLR

What is the issue?

First issue is that the borrower is not getting the benefit of lower MCLR (at least the new borrowers are not).

The bigger worry is that you are stuck with a higher spread. I doubt the bank will revise the spread downwards. Please correct me if you have evidence to the contrary.

If you had borrowed in July 2016, you would have got loan at 9.45% p.a. (1-year MCLR 9.2% + 0.25% spread).

However, if you borrow in August 2016, you will get home loan at 9.45% again. However, the break up is 9.1% MCLR and 0.35% spread.

Do note the interest rate will not change till the next interest reset date. In case of loan from ICICI Bank, since home loans are linked to 1-year MCLR, the interest reset dates will be a year apart.

If you took home loan in July 2016, your home loan interest rate will change only in July 2017 (next interest reset date). It does not matter if the 1-year MCLR goes up or down in the interim. Your home loan interest rate will change only after 1 year.

With a few banks, home loans are linked to 6 month MCLR. With such loans, interest reset dates are 6 months apart.

Let’s consider an example to see how a higher spread (to begin with) is disadvantageous to the borrower.

Illustration

A takes a home loan in July 2016 at 9.45% p.a. (1-year MCLR of 9.2% p.a. + Spread of 0.25%).

B takes a home loan in August 2016 at 9.45% p.a. (1-year MCLR of 9.1% p.a. + Spread of 0.35%).

Now, let’s suppose the MCLR gets revised in January 2017 to 9.3% p.a. and stays there.

Interest rate for A won’t be revised till July 2017 and the rate for B won’t be revised till August 2017.

In July 2017, rate for A will become 9.55% p.a. (9.3% + 0.25%).

In August 2017, interest rate for B will become 9.65% p.a. (9.3%+0.35%).

B pays more than A (for no fault of his).

You can see you are at a disadvantage if you started with a higher spread. And why did you start at a higher spread? It is because bank could not control MCLR (it went down the bank could access cheaper funds). However, it still did not want to lend at a lower rate. So, it increased the spread.  Essentially, the bank converted adversity into an advantage.

Are other banks doing this too?

I don’t have historical MCLR and spread for other banks but it is unlikely that this will be limited to just ICICI Bank.

Bank of Baroda has explicit strategic premium to take care of a similar situation.

I am not sure what other banks are doing.  Do let me know your experience with specific banks in the comments section.

How could ICICI  Bank increase the spread?

Please understand this is merely a conjecture.  My understanding might be flawed.

As per RBI circular on MCLR, spread has two components viz. business strategy spread and credit risk spread. Credit risk spread depends on the risk profile of the borrower and I do not expect that to change in a month for a similar borrower.

However, banks can easily justify business strategy spread. Even though I do not have the breakup for ICICI Bank home loan, it is quite possible ICICI Bank nudged up the business strategy spread for this month.

For instance, Bank of Baroda adds a strategic premium of 0.25% p.a. i.e. the floating rate loans are given at MCLR + Strategic Premium + Credit spread. As on August 4, 2016, base rate for Bank of Baroda is 9.6% p.a. while 1-year MCLR is 9.40% p.a. But the Strategic premium of 0.25% p.a. takes it to 9.65%.

What about those planning to switch from Base Rate to MCLR?

You must keep this spread aspect in mind.

Continuing with same example, it would be better to switch when the spread is lower.  I assume that the switch is advantageous i.e. no. of EMIs saved (and amount saved therein) is much higher than the switch fee.

And do not forget that you have to pay switch fee (and service tax) upfront while you save the EMIs towards the end of the tenor.