Marginal Cost of Funds Based lending rate (MCLR)

Starting April 1, 2016, all floating rate loans (and select fixed rate loans) are now linked to Marginal Cost of Funds based Lending Rate (MCLR). You will get loans at a spread over MCLR. What is MCLR? How is it calculated? How is it different from Base Rate regime? Why has RBI asked banks to shift from Base Rate to MCLR? And does it benefit you? Can you switch your existing loan from Base Rate to MCLR? If yes, should you switch from Base Rate to MCLR? These are some of the questions I will try to answer in this post.



Why this shift to MCLR?

In the past two years, RBI has cut interest rates by 150 basis points (1.5%). However, entire interest rate cut has not been passed to the borrowers. Most banks have passed only 60-80 basis points (0.6-0.8%) to the customers.

Banks have few genuine reasons for the same but it cannot be denied that there is reluctance too. By continuing to lend at higher rates, banks make more money. And who doesn’t want to make more money? Moreover, there is just one Base Rate. If a bank cuts base rates, the interest rate goes down not just for new borrowers but also for old borrowers. So, not only do you make less money from new customers, you also make less money from the old customers.

Common excuses/reasons were deposit rates are still high since the rates on small savings scheme were high. Even though borrowing costs (for the banks) have come down, they can say they have old deposits that were taken at a higher rate. I think RBI got fed up with all these excuses. Hence, they decided to link lending costs to the marginal (incremental) cost of borrowing. That’s marginal cost of funds based lending rate or MCLR for you. So, essentially RBI is saying if you can borrow at lower rates, lend at lower rates. It does not matter if you borrowed at higher rates in the past. Hence, the new loans from April 1, 2016 have been linked to MCLR. You will get loans at MCLR + Spread.

How is MCLR calculated?

To calculate MCLR, you have to look at all the sources of borrowing for banks. Banks don’t just borrow through fixed deposits or savings accounts. The banks offer current accounts. They borrow from wholesale markets and certificates of deposits. You can use interest rate of offer on these sources borrowing to get the marginal cost of borrowing. However, a bank’s source of funds is not just borrowing but its equity (infused or retained earnings) too. Hence, it is not irrational to expect some return on equity (or net worth) too.

RBI prescribes the following formula for marginal cost of funds:

Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%

For detailed calculation methodology, you can refer to the RBI Circular.

And that’s not it. Banks have to maintain cash with the Reserve Bank (Cash Reserve Ratio, currently at 4%). Banks don’t earn any interest on this deposit. Under MCLR, banks are given some allowance for that. Call that Negative Carry on CRR.

Then, there are operating costs to be taken care of.  Banks incur many expenses on setting up branches, salaries, raising funds etc which are not directly charged to customers. There is some allowance for that too.

Finally, there is tenor premium/discount. Tenor is the interest rate reset period. Expectedly, higher the interest reset period, higher the tenor premium.

To sum up, MCLR depends on marginal cost of funds, negative carry on CRR, operating costs and tenor premium or discount.

There shall be at least five MCLRs

RBI mandates at least 5 MCLR viz. overnight, 1-month, 3-months, 6-months and 1-year. Banks can have MCLR of longer tenures if they so desire. Here is MCLR announced by HDFC Bank. You can see they have declared for 2 year and 3 year tenor too.

Banks have to declare MCLR for various tenors every month. All new loans in that month will be offered at a spread over the MCLR. Spread will depend on credit worthiness of the borrower. However, interest rate for existing loans will be revised only on interest reset date, which will be specified in the agreement. Loans that are linked to 3-month MCLR will have a 3-month interest reset period. Similarly, loans that are linked to 1-year MCLR will have 1-year interest reset period. More on this later in this post.

Banks such as Kotak Mahindra Bank have linked home loan interest rates to 6-month MCLR while ICICI Bank and SBI have linked home loan interest rates to 1-year MCLR. You might ask, which MCLR did I find using the method in the previous section? RBI has specified the procedure in circular and FAQs on MCLR.  It depends on the spread of bank’s borrowing across various maturities.

Once you know the MCLR that you have found, you just need to adjust it with tenor premium/discount to find MCLR for other tenors.

And the Spread?

MCLR gives you the cost of incremental borrowing. But MCLR does not take into account the risk that the bank takes in lending to you. You might default. To account for such risk, the bank charges a spread over the MCLR. Hence, spread is a measure of risk. The more creditworthy you are, lower the spread. Under MCLR regime, this spread can be revised for a customer but not without conducting the full risk profile exercise for the customer.

My loan is linked to Base Rate. Can I switch to MCLR?

Yes, you can. This will happen on terms agreed between you and your bank.  Your bank may even charge a fee for it. You have the option of continuing with the Base rate. Banks will continue to publish base rates too from time to time.

Which is better for you? Should I switch from Base Rate to MCLR?

Base rate is linked to Average Cost of Funds while MCLR is linked to incremental cost of funds. Because of this, you would expect policy transmission to be slower under Base rate regime (than under MCLR regime). And banks show greater willingness to increase base rate than to decrease it. We may not like it but that is an acceptable business decision. RBI does not like it either. That’s why the central bank introduced MCLR.

MCLR is clearly more transparent. Banks cannot have it both ways, where they reduce deposit rates and keep the lending rates high. MCLR links the lending rates to cost of incremental deposits. There isn’t much bank can do. Or so I think.

With MCLR, you can expect transmission to be much quicker. But it can be a double edged sword. Just as rate cuts will be passed quickly under MCLR regime, rate hikes will be passed quickly too. You need to aware of this aspect. And we also need to consider the frequency of change. Under the base rate regime, the applicable interest rate would have changed as soon as the base rate is changed.  Under MCLR, the interest rate will be revised only on interest reset dates.

Suppose your loan is linked to 1-year MCLR and your rate was revised in April 2016. Your next reset date is in April, 2017. Your interest rate will remain constant till April 2017. It does not matter to you if 1-year MCLR gets revised in May 2016. Your interest reset date is in April 2017.  Your loan interest will be revised only in April 2017 (linked to MCLR prevailing in the interim). Do note a few banks such as Kotak Mahindra Bank have opted for 6-month MCLR for home loans. This means your loan interest rate will be subject to revision every six months.

Of course, the bank can change spread in the interim. However, since it can get operationally difficult for the banks to change spread, I am ignoring this prospect.

Because of this interest reset period, you may not be able to reap full benefits of interest rate downcycle under MCLR regime. On the other hand, in an interest rate upcycle, you may get relief under MCLR till your interest reset date comes. You can see the decision is not so crisp. If your loan is linked to base rate, do not rush to switch to MCLR. Wait for some time, assess the situation and then take a call. A point where MCLR clearly scores over Base rate is that it is more transparent. Banks may not have too much discretion. Unless you feel bankers are crooks (many of us feel so), stay put and decide later. Do note you cannot switch back to Base Rate once you have switched to MCLR.

What about other types of loans?

In this post, we have focused on floating rate loans. However, there are many loans which are offered on fixed rate basis. What about those loans? Can banks still run riot with such loans? Not really. Fixed rate loans with tenor less than 3 years are also covered under MCLR regime. Many types of loans such as personal and car loans are typically fixed rate loans. Though I do not completely understand the implications of including fixed rate loans under MCLR, you can expect banks to try to push the tenor of fixed rate loans beyond 3 years to retain pricing power.

Conclusion

MCLR is a good step forward. It is clearly more transparent and easier to relate too. As a customer, you must welcome transparency. However, don’t get too excited. Many of us were excited when base rate replaced BPLR regime a few years back. Wait for some time. New loans will be offered only on MCLR. Hence, there is not much you can do about it. About the existing loans, do not rush to switch from Base rate to MCLR. It is still early days. Wait and check the level of MCLR as compared to base rates for a few months. Make an informed decision subsequently.

 



2 responses to “Marginal Cost of Funds Based lending rate (MCLR)

  1. Hello Deepesh, Thanks for explaining the MCLR thing…
    I have taken loan from IDBI 2 years back and they are checking if I need to change it from base to MCLR?

    Base rate: 9.75
    MCLR: 9.45

    My loan is for 129 months. If I switch to MCLR then it will reduce to 126 months.

    Should I opt for it or wait until get some clarity?

    Waiting for your response.

    Regards,
    Lokesh

  2. I have taken star home loan from BOI on September 2015, it was mentioned “floating interest rele”
    Therefore should I shift to MCLR or it is automatically changed to presente interest rate.
    I still paying same EMI

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