Ever since MCLR (Marginal Cost of funds based Lending Rate) came into existence from April 1, 2016, a question that I have been asked multiple times is “Should I switch from Base Rate to MCLR?” The frequency of these questions grew after various banks cut their MCLR sharply after the demonetisation drive.
How Can I Switch from Base Rate to MCLR?
Banks allow existing borrowers on base rate to switch to MCLR after payment of applicable fee. A few banks charge a flat fee for the same while the others charge a percentage of outstanding loan amount or sanction amount. I have found percentage of outstanding loan to be the most common option.
Should I Switch from Base Rate to MCLR?
If your home loan is still on base rate, this is one question you would like to find an answer to. Not simple to answer as you have to take upon multiple assumptions. You don’t know how MCLR and Base Rate will change in the future. Will the delta between MCLR and Base Rate remain same (unlikely) and keep changing? Then, there is fee involved. And don’t forget GST. Moreover, fee is to be paid upfront while the cost saving will be towards the end of loan tenure through reduced number of EMIs. However, you can do a simple spreadsheet analysis (of course with a few assumptions) to arrive at your decision. I have discussed this in an earlier post. Therefore, wouldn’t touch upon this aspect.
The Importance of Spread
Every floating rate loan is offered at a Spread over the Benchmark.
Your loan interest rate = Benchmark + Spread
MCLR and Base Rate are benchmarks. Spread is expressed as a percentage and is a reflection of your credit-worthiness and also a parameter used by bank to control interest rate offered to you. Clearly, lower the spread, the better it is for you. Note that benchmark keeps varying while the Spread remains constant for loan term. Therefore, if you happen to contract a higher spread at the time of loan sanction, you will have to live with it for the entire loan term (unless you pay a fee for reducing spread or take a balance transfer to other banks).
And banks play tricks with this approach. Something similar was seen in January 2017 (after demonetization drive) when the banks had to cut MCLR sharply but the Spread was increased to compensate for the spread. I have discussed this aspect in detail in this post.
There Is an Option to Switch without Paying a Fee
As mentioned above, if you want to switch from base rate linked loan to MCLR, there is give and take involved. You have to pay a fee. And that complicates the decision because of timing of cashflows (fee is upfront while saving is towards the end of loan tenure). Moreover, many of us don’t like to pay fee for anything. Recently, while going through posts on a popular Facebook group, I found out that SBI was giving two options to its existing base rate borrowers to switch to MCLR.
- With fee. You move to prevailing MCLR + Spread
- Without paying any fee. Your loan becomes linked to MCLR (instead of Base Rate). However, the effective loan rate does not change. This means Spread over MCLR is adjusted such that the loan rate does not change. Subsequently, as and when MCLR changes, your loan rate will also fluctuate (after interest-reset period).
Is There an Issue with the Second Approach?
We have discussed first approach at length in earlier posts. What about this second approach? To a few of us, it may seem fine. You get to switch to MCLR without paying a fee. There is a caveat though. Let’s find out more.
Let’s assume 1-year MCLR for SBI is 8%. Let’s further assume that a person with your profile would have got loan at a spread of 0.5% p.a. Loan interest rate = 8.0% MCLR +0.5% spread = 8.5% p.a.
Now, you have a base rate linked loan with Base rate of 9% with a spread of 0.25% p.a. Therefore, your effective loan rate is 9.25% p.a. You decide to switch to MCLR without paying any fee. Now, MCLR is same for everyone. Therefore, to maintain the same loan interest rate of 9.25%, your spread will be jacked up to 1.25% p.a. Your loan after switch will be at 8% MCLR + 1.25% spread = 9.25% p.a.
And you are stuck with this spread for life of the loan. Contrast this with the rate the new borrower gets. The spread for the new borrower is only 0.5% p.a. You will always pay 0.75% higher than the new borrower. After 1 year (when the interest rate resets), let’s assume the 1-year MCLR is 8.25% p.a., you will pay 9.5% while the other borrower pays only 8.75%. You need to determine if the fee saved is worth paying 0.75% p.a. more for the entire loan term. Essentially the problem we discussed in our post about MCLR spread.
In most cases, you are likely to end up paying much more than fee saved. To take up an example, suppose you had an outstanding loan of 35 lacs with remaining tenure of 15 years. Compare with a new borrower who takes a loan of Rs 35 lacs with a tenure of 15 years. Assuming rates stay the same, over the loan tenure, you will pay Rs 2.8 lacs more in form of interest. Clearly, I have chosen the numbers to suit my argument. However, the argument is likely to hold true in most cases. Firstly, the only reason why you will think about switching from Base rate to MCLR is when the difference between loan rates for the two has to grown too wide for your comfort.
Under the second option, you continue at the same rate for at least another year since the spread has been adjusted upwards. Frankly, what’s the point in switching if you have to pay the same rate for the next one year? If this is not enough, you are stuck with a high spread for the entire tenure of the loan. You can still do your own numbers but the second option is unlikely to make sense in most cases.
What Should You Do?
When everyone is going gaga over switch to MCLR, a few of us may skip this important technicality and choose the second option (without fee) to save an upfront outgo. You will have to pay a lot more during the loan term. Don’t fall for the trap. With banks, there is never a free lunch.
SBI website only makes mention of Fee option. Therefore, I couldn’t independently verify the second option. However, banks can always make this offer or any other innovative offer. You need to be aware about how floating rate loans work.