Should I Switch My Home Loan from Base Rate to MCLR

Should I switch my home loan from base rate to MCLR? Many readers of EMICalculator have have asked me this question by e-mail or in a comment on the website. A typical query goes like this:

I have an outstanding loan of, say, 20 lacs at, say, 9.8% per annum. It is a base rate linked loan. My bank has offered me to switch to MCLR linked loan by paying, say, Rs 20,000.  MCLR loan is currently at 9.3% p.a. Should I switch from base rate linked loan to MCLR linked loan by paying the fee?

What will you do in such a case? In this post, let’s see how you should approach this question. As we will see in this post, there cannot be a fixed answer. You will have to work out a few numbers to make a decision.

Do a Bit of Math

You must see if the savings justify the switch cost. Let’s try to understand with the help of an example.

Base Rate + Spread	9.80%
Loan Amount	20 lacs			40 lacs
Outstanding Tenor (Years)	5	10	20	5	10	20
EMI Under Base Rate	42,298	26,209	19,036	84,595	52,418	38,072
Interest under Base Rate	2,537,852	3,145,097	4,568,680	5,075,705	6,290,194	9,137,360
MCLR + Spread	9.50%
EMI Under MCLR	42,004	25,880	18,643	84,007	51,759	37,285
Interest under MCLR	2,520,223	3,105,541	4,474,230	5,040,447	6,211,083	8,948,459
Savings in Interest Cost	17,629	39,556	94,450	35,258	79,112	188,901
MCLR + Spread	9.25%
EMI Under MCLR	41,760	25,607	18,317	83,520	51,213	36,635
Interest under MCLR	2,505,588	3,072,785	4,396,161	5,011,176	6,145,571	8,792,322
Savings in Interest Cost	32,265	72,312	172,519	64,529	144,624	345,039
MCLR + Spread	9.00%
MCLR + Spread	9.00%	9.00%	9.00%	9.00%	9.00%	9.00%
EMI Under MCLR	41,517	25,335	17,995	83,033	50,670	35,989
Interest under MCLR	2,491,003	3,040,219	4,318,685	4,982,005	6,080,437	8,637,369
Savings in Interest Cost	46,850	104,879	249,995	93,700	209,757	499,991

You can see that your savings increase with the increase in loan amount, loan tenor and the interest rate differential. However, there is an issue with the above approach. Typically, the bank does not alter the EMI based on change in underlying interest rate. It merely changes the tenor. If the bank alters the tenor (and not the EMI), your savings will only be towards the end of the loan tenor.  Let’s see how the numbers look like in case of adjustment in tenor (and not EMI).

Base Rate + Spread	9.80%
Loan Amount	20 lacs			40 lacs
Outstanding Tenor (Years)	5	10	20	5	10	20
EMI	42,298	26,209	19,036	84,595	52,418	38,072
Original number of Instalments (in months)	60.00	120.00	240.00	60.00	120.00	240.00
MCLR + Spread	9.50%
New number of Instalments (in months)	59.47	117.51	226.02	59.47	117.51	226.02
Net Savings	22,496	65,238	266,064	44,992	130,477	532,129
MCLR + Spread	9.25%
New number of Instalments (in months)	59.03	115.55	216.18	59.03	115.55	216.18
Net Savings	40,832	116,711	453,424	81,663	233,422	906,849
MCLR + Spread	9.00%
New number of Instalments (in months)	58.61	113.67	207.58	58.61	113.67	207.58
Net Savings	58,808	165,783	617,141	117,615	331,565	1,234,283

You can see the savings in the second approach are much higher as compared to the first approach. However, don’t get confused. In the first approach, you are saving every month in terms of reduced EMI. On the other hand, in the second approach, you are saving only towards the end of the loan tenor. That’s why the numbers look higher in the second approach.

In this post, I will consider second approach unless specifically mentioned. A point to note is that I have assumed interest rate to be constant throughout the loan tenor, which is not a practical choice. It is quite possible that the difference in base rate or MCLR may narrow down or widen in the future. However, it is not possible for me to forecast base rate and MCLR. Hence, I will stick to this analysis only.

Compare the Savings with the Switch Fee

Now that you know the net savings, you must compare it against the switch fee. Let’s consider two cases.

1. For a loan of Rs 40 lacs with tenor of 20 years and interest rate of 9.8%, the savings from switching to MCLR rate of 9.25% will be approximately 9.06 lacs. Now, suppose the bank offers you to switch your loan to MCLR at a fee of Rs 50,000, should your switch? Rs 50,000 is a very small number as compared to Rs 9.06 lacs. However, you have to shell out Rs 50,000 today while saving of Rs 9.06 lacs is spread from 18th till 20th year. You need to account for this difference in timing of cash flow. Rs 50,000 if invested at 8% will grow to Rs 2.33 lacs. Even if you can find an investment that delivers a return of 10% p.a., Rs 50,000 will only grow to Rs 3.36 lacs. Hence, it makes sense to switch.
2. If the bank had demanded Rs 50,000 for a 5 year loan (switch from 9.8% to 9.5%), your net saving is only Rs 44,992. Rs 50,000, if invested at 8%, will grow to Rs 73,466 in 5 years. Hence, it does not make much sense to switch.

Clearly, you benefit more from the switch when:

• The outstanding loan amount is higher
• Difference between base rate and MCLR is high. Consider the spread too.
• Outstanding tenor is high.
• Switch fee is lower.

Do You Plan to Prepay the Loan?

You must absolutely consider this aspect. We have seen the net savings from the switch are low when the loan amount is small and the loan tenor are short. If you plan to prepay the loan, the loan tenor will go down and the outstanding principal will also go down sharply. In such a case, rather than paying a fee to switch loan to MCLR, consider pre-paying the loan with the switch fee amount. 

For instance, suppose you have loan of Rs 20 lacs at 9.8% for 5 years. Your bank is asking for a fee of Rs 30,000 (incl. service tax) to switch loan to MCLR at 9.25%. By switching loan to MCLR, you will save Rs 40,832. However, by prepaying home loan with the same Rs 30,000, you will save Rs 49,109. In this specific case, it makes more sense to prepay rather than switch to MCLR. I am not saying that the mathematical outcome will always support pre-paying the loan with the switch fee amount. It may or may not.

I have chosen the example to suit any argument. You must work out the numbers for your specific case. Do consider the ‘Switch to MCLR’ aspect. Similarly, if you are planning to prepay your loan aggressively, the benefits of switch to a lower rate will go down. In such a case, do consider pre-paying rather than switching to MCLR.

Points to Note

1. Your bank may charge a flat fee or a percentage of the outstanding loan. It is completely bank’s discretion. However, the way to analyse remains the same.
2. Your bank will also charge service tax on the switch fee.
3. MCLR can a double edged sword. Just like MCLR linked loan rates are likely to move down faster (than base rate linked loan) when interest rates are going down in the economy, MCLR rate will rise just as swiftly when the interest rates move up. However, given the banks’ propensity to pass on rate hikes much quicker than passing on interest rate cuts, I wouldn’t worry much about this aspect.
4. MCLR has an associated interest rate reset period. So, if your home loan is linked to 1-year MCLR, your interest reset dates will be 1-year apart. Hence, even if 1-year MCLR moves down in the interim, your applicable interest rate will change only on the next interest reset date.

MCLR is more transparent than the base rate. I am not saying banks will not figure out a way. I think the banks already are. However, I feel they have much more leeway in case of base rate. Hence, everything else being the same, MCLR is a better option than base rate. However, do not rush to switch. Do your math and make an informed decision subsequently.