Do Not Ignore Spread While Switching from Base Rate to MCLR

[pullquote]A floating rate loan is offered at a spread over the benchmark. MCLR and Base Rate are benchmarks. Loan is given at MCLR (or Base Rate) + Spread.[/pullquote]

I have discussed the question of whether you should switch your home loan from Base Rate to MCLR in an earlier post. Most of us focus only on the interest rate and the switch fee while deciding but tend to ignore spread while making the decision to switch from Base Rate to MCLR. From April 1, 2016, all floating rate loans are offered at a Spread over MCLR. For instance, if MCLR is 9% p.a. and spread is 0.50%, the effective interest rate for your loan is 9.5% p.a. MCLR linked loan has a reset period. For many banks, home loan is linked to 1-year MCLR. If your loan is linked to 1-year MCLR, the applicable MCLR will remain constant for 1 year and will reset thereafter. In this post, I will discuss how loan spread can affect your decision to switch from base rate to MCLR.

MCLR Is Variable, Spread Is Constant

MCLR will change once the reset period gets over but the spread will remain constant. Therefore, the spread will remain same for the entire tenure. Do note home loan agreement is a contract and can be worded in any way. The contractual terms may even leave a scope for revision of Spread. However, MCLR regime makes it difficult to change Spread. In any case, banks are unlikely to cut Spread since there is no compulsion.

How Does This Affect You?

If I were to you tell you that you could get home loan at 9% p.a. and gave you two options.

  1.    Bank A: MCLR of 8.5% and Spread of 0.5%
  2.    Bank B: MCLR of 8.25% and Spread of 0.75%

Which option will you choose? Higher Spread or a higher MCLR? I would prefer a lower spread because MCLR will keep changing while the spread will stay constant. After 1 year when the MCLR resets (assuming home loan is linked to 1-year MCLR), spread will still stay the same. Suppose, after 1 year when MCLR resets, 1-year MCLR for both the banks is 8.75% p.a. Under Bank A loan, you will have to pay 9.25% p.a. while under loan from Bank B, you will have to pay 9.5%. This is because loan spread has remained constant. Since the spread for Bank B was higher to begin with, the effective interest rate is higher for Bank B loan once MCLR resets.

You may argue that Banks A and B are different and it is quite possible that the difference between MCLRs and Spreads may stay that way. You are right. It may stay that way but it does not undermine the role Spread can play. You must be aware of this aspect.

Banks May Cut MCLR and Increase Spread

SBI cut 1-year MCLR sharply from 8.9% p.a. to 8% p.a. on January 1, 2017. To compensate for the cut in interest rate, the spread was raised sharply from 25 bps to 65 bps.

Let’s consider an example.

  1. Amit took loan on December 30, 2016, would have got loan at 9.15% p.a. (8.9% +0.25%).
  2. Mukesh took loan on January 1, 2017, would have got loan at 8.65% p.a. (8% + 0.65%).

Suppose both took loans of Rs 50 lacs for 20 years. Amit’s EMI will be Rs 45,470 while Mukesh’s EMI will be Rs 43,867. A difference of ~ Rs 1,600 per month. Mukesh would consider himself lucky that he/she delayed the loan process by a couple of days. I assume affordability is not an issue for either Amit or Mukesh.

Should Mukesh Really Be Happy?

Yes, for now. Fast forward 1 year when the MCLR for Amit and Mukesh resets. Suppose after 1 year, MCLR is 8.25% p.a.

  1. Rate of interest for Amit’s loan will be 8.5% (8.25% MCLR + 0.25% spread).
  2. Rate of interest for Mukesh’s loan will be 8.9% p.a. (8.25% MCLR + 0.65% spread).

Who will be smiling then? I am sure Mukesh won’t be so happy. And this will happen. Amit and Mukesh took loan from the same bank. Same MCLR will apply to both of them after 1 year.

Loan Amount (Rs lacs)5050
Original Loan Interest Rate9.15%8.65%
Loan Tenure240240
Principal O/S after 12 months4,908,0714,902,282
Case 1: EMI remains constant
Interest Rate After 1st  year8.50%8.90%
No. of EMIs to repay the loan217251
Total interest paid during loan tenure (Rs lacs)48.6360.05
Case2: Loan Tenure remains constant
Principal O/S after 12 months49080714902282
Interest Rate After 1st  year8.50%8.90%
Remaining Loan Tenure228228
Total interest paid during loan tenure (Rs lacs)54.5457.04

Assuming EMI stays constant (after change in interest rates) and interest rates stay this way during loan the loan tenure, Amit will be able to repay the loan in 205 months (217 months in total) while Mukesh will be able to repay loan in 239 months (251 months in total). Total interest paid by Amit during the loan tenure will be ~ Rs 48.6 lacs while Mukesh will pay interest of ~ Rs 60 lacs.

Assuming tenure stays constant and EMI changes, Amit’s EMI will go down to Rs 43,458 while Mukesh EMI will go up to Rs 44,639. A difference of Rs 1,180. Amit’s EMI will be lower by Rs Rs 1,180 for the remaining 19 years.

To be honest, this is sheer luck. You wouldn’t possibly wait for the MCLR cut or the spread to go down before you take the loan. You will take a loan when you need it. Therefore, this is not really a decision point.

What about Base Rate to MCLR Switch?

This is where this aspect assumes importance. For instance, if a SBI base rate borrower had converted to MCLR in December 2016, he would have switched at MCLR of 8.9% and spread of 0.25% at an effective interest rate of 9.15%. If you switched at MCLR of 8% and spread of 65 bps, the effective rate will be 8.65% p.a. Clearly as shown above, you would prefer to switch when the spread is lower. Do note that I am not saying that you must not switch from base rate to MCLR just because the spread is high.

Should You Wait to Switch till the Spread Moves Down?

How long will you wait?  What if spread does not go down for a few years? In fact, you may just keep waiting. Do not ignore the cost of staying in a high rate loan (base rate loan).

Let’s suppose your base rate linked loan is at 9.75% and MCLR linked loan is available at 8.65% (MCLR of 8% and spread of 0.65%). Suppose you had taken loan for Rs 50 lacs five years ago at 9.75% p.a. for 20 years. After 5 years, the principal outstanding will be Rs 44.76 lacs (assuming rate stayed constant at 9.75%). You have an option to switch to MCLR at a spread of 0.65%. You can see that the spread is high. If you wait for spread to come down for 1 year and continue with loan at 9.75%, your principal O/s will be Rs 43.38 lacs after 1 year. Had you switched to MCLR, your loan outstanding after 1 year will be Rs 42.87 lacs. Therefore, by switching, you have repaid faster. Difference in loan outstanding is over Rs 50,000.

Therefore, you are hurting yourself while you wait for a lower spread. The principal outstanding goes down much more quickly in a low interest rate loan (if you keep the EMI same).

I will not do a mathematical analysis for this question because the choice of interest rates, switch fee and spreads will affect final result. I leave it to you to decide. If I were you, I wouldn’t wait too long for the spread to go down. The delay in switching will hurt me. I know this decision can backfire (and so can the decision to switch from base rate to MCLR). So be it. There are a few things that I don’t control. Just that I need to be aware that there is risk involved.

By the way, home loan refinancing is an option available to you if you are stuck with a higher spread. Therefore, if you want to switch from base rate to MCLR but a high spread worries you, you can switch your loan to a bank where spread is low.

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