Reserve Bank of India has directed all scheduled commercial banks to shift to MCLR (Marginal Cost of Funds based Lending Rate). This means all new loans sanctioned on or after April 1, 2016 will be linked to MCLR.
MCLR stands for marginal cost-based lending rate. Earlier, your loans were priced at a spread over the Base Rate. For instance, if the base rate was 9.5% p.a. and the spread was 50 bps for your risk profile and loan tenor, you will have to pay 10% p.a. on your loan. From April 1, 2016 MCLR will replace Base Rate. All the new loans will be offered at MCLR + Spread.
What is MCLR? What is the need to shift to MCLR? How is MCLR calculated? How does it affect you? These are some of the questions I would try to answer in this post.
Why MCLR (Marginal Cost of Funds based Lending Rate)?
You have been hearing about RBI has cut interest rates many times over the last two years. However, your home loan EMI has not gone down that quickly. Banks have been reluctant to pass on these rate cuts (in form of lower interest rates) to borrowers like you. Why?
Banks have been giving one excuse or the other for not reducing lending rates. Before MCLR, lending rate was linked to the Base Rate. There was just one base rate for all the loans. You were given loan at Base Rate + Spread. This Spread was constant during the term of the loan (could be changed only in case of default or breach of terms of the loan agreement). If the bank reduced Base Rate, interest rate on both new loans and old loans will go down.
In case of rate cuts by the Reserve Bank, banks could always say that even though the cost of fresh borrowing has gone down, they have legacy deposits for which the interest rate remains high.
There was nothing beyond a point that RBI could do to ensure quick transmission of interest rate cuts.
To counter this, RBI has introduced MCLR so that banks link their lending rates to marginal funding costs (cost of fresh or incremental borrowings).
With MCLR, the RBI wants to ensure that the lending costs are in line with the cost of fresh (incremental) borrowing. Hence, if the bank cuts the rates on deposits, it will automatically have to transmit the cut in deposit rates to lending rates. By cutting the deposit rates, the bank brings down its marginal cost of funds because it can raise deposits at a lower interest rate.
So, the rationale is simple. If you can borrow at lower rates, lend at lower rates.
How is MCLR calculated?
You can expect MCLR to be linked to fresh (incremental) cost of borrowing. However, there is more to it. Borrowing is not just rates of fixed deposits. It includes current account balances, savings account balances, wholesale borrowings, borrowings from RBI.
But there is more to it. Let’s look at various components of MCLR.
- Marginal Cost of Funds: This is cost of fresh (incremental) borrowing to the bank. It takes into account interest rates of different types of deposits (current, savings, term deposits etc). Marginal cost of funds is not just the deposits (borrowings) that the bank has accepted. There is some equity too. Hence, cost of equity is also considered.
Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%
For exact calculation, you can refer to the RBI Circular.
- Negative Carry on Cash Reserve Ratio: 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
- Operating Costs: Bank’s costs are not limited to interest it pays on deposits. There are expenses on salaries, branch rent or other expenses that are not directly charged to the customers. Cost of raising funds is also included under this head.
- Tenor Premium/Discount: Higher the loan tenor, higher the tenor premium. Tenor refers to the period of interest rate reset. Even though your loan tenor is 15 years but if the loan reset is done every year, 1-year MCLR will be applicable.
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How many MCLRs?
The Reserve Bank has directed banks to set at least 5 MCLR rates viz. overnight, 1 month, 3 months, 6 months and 1 year. The banks can choose to have more (for longer tenors).
You might ask, which MCLR did I arrive at using the formula in the previous section? That depends on the distribution of bank’s deposits across various maturities. RBI has specified procedure to find out. You can refer to RBI Circular for the same.
Once you have arrived at marginal cost of funds with adjustment for CRR and operating costs and know the applicable tenor, you apply tenor premium/discount to arrive at other MCLRs.
For instance, if the MCLR was for 6 months, you will apply tenor discount for overnight, 1-month and 3-month MCLR. On the other hand, you will apply tenor premium for 1-year (or higher tenor) MCLR.
RBI has not specified how to calculate tenor premium/discount. It is bank’s discretion.
All the loans will be offered at applicable MCLR + Spread.
What about this spread?
MCLR is merely to assess the cost of funds to the banks.
The banks will also charge a premium based on your credit worthiness. The spread may depend on your credit score or bank’s assessment of your repayment ability.
The banks can change the spread in MCLR linked loans (could not do so earlier in base rate regime). However, it is not so easy.
The spread charged to a customer can be increased only in case of deterioration of credit risk profile of the borrower. Such decision must be supported by complete risk profile review of the borrower. Hence, increasing the spread may become operationally difficult for the banks.
When will Banks publish MCLR? When will the interest rate be reset?
The MCLR will be reviewed on a monthly basis i.e. banks will disclose MCLR for various tenors every month. All the new loans during the new month will be offered at latest MCLR +Spread.
However, your loan interest rate may not get revised every month. It will be done at the next interest rate reset date as provided under the loan agreement between you and the bank. This interest reset period cannot be greater than 1 year.
For instance, your loan is linked to 1-year MCLR (say 9.1% p.a.) and the next reset date is March 1, 2017. Even if 1- MCLR is revised downwards to 8.9% p.a. in May, 2016, you will have to wait for at least till March 2017 before a lower MCLR can apply to your loan. Please remember 1-year MCLR announced for the month of March 2017 will apply to your loan at the next reset date.
Reset period is at the discretion of banks. Kotak Mahindra Bank has chosen to reset home loan interest rates every six months (Kotak Mahindra Bank is using 6-month MCLR for home loans). On the other hand, SBI and ICICI Bank will reset home loan interest rates after 1 year (SBI and ICICI Bank are using 1-year MCLR for home loans).
These are the MCLR rates for various maturities announced by SBI.
You are not really concerned about how MCLR is calculated. Are you? You want to know how it affects you as a borrower. Will your monthly EMI go down after MCLR is introduced?
How does MCLR regime affect you?
In this section, I consider the borrowers who take fresh loans under MCLR regime.
At the outset, it appears that interest rate policy transmission should be much quicker in MCLR regime (as compared to Base Rate regime). MCLR is more transparent.
If the RBI cuts repo rates and cost of borrowing in the system goes down, you can expect reduction in your EMI much sooner.
The only issue is that you will have to wait till the next interest reset date before you get the benefit of lower interest rate. In such cases, you may consider refinancing your loan from another lender.
Since the MCLR has to be published every month, banks cannot hide their borrowing cost from the customers.
Do note MCLR is a double edged sword. Just as you expect interest rate cuts to be passed quickly, you must also expect interest rate hikes to be passed soon. However, I don’t think it matters much. Banks are always quick to pass on the interest rates hikes. It is when they have to reduce interest rates that they keep inventing excuses.
What about the existing borrowers?
MCLR is applicable to all loans made on or after April 1, 2016. If you borrowed on or before March 31, 2016, your loan will still be linked to base rate. However, you can switch from base rate to MCLR at mutually agreed terms between you and the bank. The bank can charge you a fee for the switch.
Should you switch your home loan from base rate to MCLR?
Too early to say. It depends on what conditions (fee etc) your bank is offering you for switch. You will not be able to switch back to Base Rate Regime. Additionally, consider the spread that the bank is offering under MCLR regime. If you are getting a better deal under MCLR regime, then you can switch.
With housing loans, you can always refinance your loan from a lender offering lower interest without prepayment penalty; hence the MCLR regime adds only limited value.
What will be the impact on other loans?
All floating rate loans sanctioned on or after April 1, 2016 will be under MCLR regime. Even fixed rate loans up to a tenor of 3 years will be brought under MCLR regime. Fixed rate with tenor of more than 3 years will be exempt from MCLR regime i.e. banks will have discretion in pricing the product.
Typically, personal loans are less than 3 years while tenor of a car loan exceeds 3 years. You can expect banks trying to push tenor of fixed rate loan products to over 3 years to avoid MCLR regime.
I trust banks to find a way around MCLR. Hence, I am not sure of the extent to which borrowers will benefit from move to MCLR regime. Nonetheless, MCLR is clearly more transparent and it appears banks have less discretion.
Following section added on October 20, 2016
Mathematics behind decision to switch from Base Rate to MCLR
In this section, I will focus on the numbers that you need to work out to decide whether you should switch your loan from base rate to MCLR.
I will make many assumptions. For instance, I have assumed the base rate (+spread) and MCLR (+spread) will remain constant during the tenor of the loan. This assumption is extremely unlikely to hold true. However, it will give an idea about the difference a switch can make.
Banks charge a fee for switching your loan from base rate to MCLR. Banks may charge a fixed fee or a fee linked to your loan amount or use any other method. It is entirely bank’s discretion.
If you have to switch, total savings from the switch should comfortably exceed the switching fee. Remember you will have to pay service tax on the fee too.
Your decision will depend on many parameters:
- Outstanding Loan amount: Higher the loan amount, higher the savings due to reduction in interest rate.
- Outstanding Loan Tenor: Higher the loan tenor, greater than savings due to reduction in loan interest rate.
- Interest Rate Differential: Higher the difference between base rate (plus spread) and MCLR( plus spread), greater the savings. I have assumed MCLR is lower than base rate.
- Switch fee: Lower the switching fee, better the proposition for you.
Let’s try to understand with the help of an example. I have considered two loan amounts of Rs 15 lacs and Rs35 lacs, loan tenor of 5, 10 and 20 years and different values of MCLR linked loan rates. Base rate (plus spread) is assumed constant at 9.8% p.a.
You can see the savings increase with the increase in loan amount, loan tenor and the rate differential.
Now you need to compare your savings with the switch fee that the bank is charging you. Additional point to note you pay the switch fee upfront while the cost saving is through a lower EMI every month.
There is an additional issue with the above approach.
Banks typically don’t change the EMI but only adjust the tenor. Hence, the above analysis may not be very useful.
With lower interest rate (under MCLR), bank will lower the tenor and keep the EMI same.
Let’s see the impact.
You may note that the absolute savings under the second method (reduction in tenor) are higher than the first method (reduction in EMI).
Under the second method, all the saving comes at the end of the loan tenor (since the EMI remains constant). Under the first method, you save a small amount every month in the form of EMI. That explains the difference.
If you need assistance in working out these numbers, you can try EmiCalculator website.
Given these numbers, what will you do?
You compare these savings with the switch cost. Switch to MCLR if the saving is significant.
You must also note the timing of cash flows.
For instance, under the second method, all the savings are at the end of the loan tenor.
For a loan of Rs 35 lacs (outstanding amount) and tenor of 20 years, you save 23.82 EMIs by switching from base rate to MCLR (9.25%). That is a cost savings of Rs 7.93 lacs.
Let’s suppose the bank asks a fee of Rs 50,000 for the switch. You have to pay Rs 50,000 for saving of Rs 7.93 lacs. Seems like a really good proposal.
However, do not ignore that the saving will come in 19th and 20th years while the switch fee has to be paid up front. You could have invested Rs 50,000.
Rs 50,000, if invested at 8% per annum, will yield Rs 2.33 lacs in 20 years. At 10%, it will grow to Rs 3.36 lacs. By the way, you could have discounted the savings and compared with Rs 50,000.
Even after adjustments, you can see cost saving is much higher. Hence, it may make sense to switch.
However, if the bank were to ask for the same fee of Rs 50,000 (for MCLR rate of 9.5%) for a loan of Rs 15 lacs, it wouldn’t make much sense. The saving is only Rs 1.99 lacs.
Planning to prepay your home loan?
You could have also used the switch fee amount to reduce outstanding loan amount. After all, part pre-payment will also result in lower interest outgo.
If you are planning to pre-pay your loan aggressively, you must reconsider your decision to switch even if mathematics in the previous section is favorable.
This is because, as your pre-pay the loan, the outstanding tenor goes down. As the loan tenor goes down, the benefit of switching to lower interest rate will also go down.
It is quite possible that you may be better off pre-paying the loan than paying fee to switch to MCLR.
For instance, for a loan of Rs 15 lacs for 20 years, you save 1.99 lacs by switching to MCLR at 9.5% p.a. If you had used Rs 50,000 to pre-pay the home loan, then you could have saved Rs 3.36 lacs over the loan term. Hence, in this specific, you are better off pre-paying loan.
And this is just for one prepayment.
So, if you have plans to pre-pay loans, include such pre-payments in your analysis.
Do note I have chosen numbers to suit my argument.
I do not mean the pre-payment is better than switching to MCLR.
All I am saying is that pre-payment is an aspect that you must consider and that regular prepayments will lower your switching benefits.
For your case, the loan amount, tenor, rate differential, switch fee and prepayment plans will determine your course of action.
Note: Many readers have asked me in the comments section whether they should switch from Base rate to MCLR linked loan by paying a switch fee. Advise you to appreciate that, in the above analysis, I have made a few assumptions which are unlikely to hold true. For instance, it is unlikely that the interest rate differential (between MCLR and base rate linked loan) will remain constant across the loan tenor. Hence, any suggestion that I give in the comments section must be considered in this light.
Following section was added on February 26, 2017
MCLR will keep changing while the Spread is constant
Though this section should not be part of a generic post, after going through many of the comments in this post, I thought it apt to discuss this aspect. This aspect may be quite important in current scenario.
When you take a home loan, it is offered as a spread over a benchmark. That benchmark is currently MCLR. Earlier, it used to be base rate. For instance, if 1-year MCLR is 8.5% p.a. and the spread for your loan is 0.35%, you will get loan at 8.85% p.a. I assume home loans are linked to 1-year MCLR.
What you need to remember is that the benchmark keeps fluctuating while the spread usually remains constant during the loan tenor. Therefore, after 1 year, if the MCLR goes up to 9.0%, interest rate will go up to 9.35%.
Please understand home loan agreement can be structured in any way and may even leave scope change in spread. However, a few sample agreements that I have read, there was little scope for revision in spread. Even if there is provision for revision in spread, banks will be more forthcoming in revising it upwards rather than downwards. We know banks, don’t we?
Consider two scenarios.
- MCLR of 8% and spread of 0.65%
- MCLR of 8.4% and spread of 0.25%
In both cases, you will get loan at 8.65%. Which one will you opt for? Which is better?
Clearly, the one with the lower spread. Why?
In the first case, you are locking in a much higher spread.
Something similar happened recently when the MCLR was significantly cut by SBI while the spread was increased.
A took loan in December 2016 and got loan at 8.9%+0.25%= 9.15% p.a.
While if you took loan in January 2017, you would have got loan at 8% + 0.65% = 8.65% p.a.
You should be quite happy. You have saved 0.5% of interest.
However, the expression will change after a year. After one year, suppose 1-year MCLR is 8.5%.
A’s effective interest rate will be 8.75% p.a. (8.5% + 0.25%) while you will pay 9.15% (8.5% + 0.65%). Who will be smiling then?
Therefore, you will pay a higher interest for the entire loan tenure (even though you paid lower interest rate in the first year).
To be honest, this comparison is meaningless. Nobody has the gift of hindsight. Nobody knew that MCLR will be cut sharply in January and spread increased to make up for MCLR cut. Therefore, it is difficult to take action. You do not really have a choice in such cases.
However, now, many of us have a choice. Should you stick with base rate or switch to MCLR by paying a fee?
Even though I have discussed the question in detail in this post, I must reiterate that you consider this spread too while making your decision. My analysis just does not consider this aspect.
Another point to note is that spread in your base rate loan can be different from MCLR linked loan.
By the way, I do not, in any way, mean that you should not switch to MCLR just because the spread is high. A few readers have opined that existing base rate borrowers must stick to base rate so long as the spread is high.
I do not agree with such an opinion. Who tells you that this situation will not stay for a long time? For every day that you do not switch to MCLR, you keep paying higher interest rate. Higher interest payment means lower principal repayment in each EMI.
And you always have the option to change your lender (balance transfer) if you feel later that you are being short-changed by your lender.
But, do consider this aspect. And always remember there is no such thing as free lunch. And banks are the last ones to offer you a free lunch. Therefore, do not consider a switch to MCLR a win-win deal. It is never that simple.
The post was originally published on April 6, 2016 and has been updated since.
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