What Should Existing Borrowers Do in Wake of Sharp MCLR Cut?

Recently, State Bank of India cut its MCLR (Marginal Cost of Funds based lending rate) by 0.9% p.a. from 8.9% p.a. to 8.0% p.a. This is bonanza for those who are planning to take a home loan this new year. Many other banks have followed suit and cut the MCLR rates sharply. However, this rate cut may not be completely being passed on to new borrowers. For instance, SBI increased the spread by 0.4% from 0.25% to 0.65%, effectively limiting the rate cut to 0.5% even for the new borrowers. Still, 0.5% is no small cut. Ask this to existing base rate loan borrowers.

What about Existing Borrowers Who Have Loans Linked to Base Rate?

Existing borrowers will obviously feel short changed. Base rates have not been cut by a similar margin over the last 9 months. Banks have always been quite reluctant to pass on the interest rate cuts to the existing borrowers. 

As discussed in another post on MCLR, such investors have been offered an option to switch to MCLR by paying a one-time fee. You must consider the interest rate differential, outstanding loan amount, loan tenure and your prepayment plans before you decide to switch. However, do note the aforementioned analysis makes many unrealistic assumptions about base rate and MCLR outlook. For instance, the base rate and MCLR have been assumed to be constant during the loan tenure and hence the interest rate differential has been assumed to be constant. As we have seen with the recent sharp cuts in MCLR, these assumptions do not really hold true. However, the analysis does give you an idea about how a switch to MCLR affects you. The switch fee varies across banks and the Reserve Bank has no particular guideline on this matter. Typically, banks charge a percentage of the outstanding loan amount as the switch fee.

What If You Do Not Want to Pay One-Time Fee for the Switch?

In that case, you can consider getting your home loan refinanced from another bank i.e. you can transfer your home loan to another bank. The loan from new bank will square off your liability with the current bank and you will have a loan with the new bank. The new bank may charge only a fraction of switch fee towards administrative and operational charges. However, this method may not be as operationally convenient. After all, you are shifting the loan to a different bank. Switching from base rate to MCLR can be easily done by paying a fee. The entire process will be quite operationally convenient. You will not have to run around. Hence, you need to weigh the cost and convenience.

What about Existing MCLR Borrowers?

Even for the existing MCLR borrowers, the cut in MCLR will not be passed on immediately. There is an interest reset period associated with MCLR loans. For instance, if you took a home loan in August 2016 and your home loan is linked to 1-year MCLR, your effective home loan interest rate (or the applicable MCLR) will change only after August 2017. This is irrespective of what happens to 1-year MCLR in the intervening 12 months. Hence, you will have to wait for another 8 months before this sharp MCLR cut brings you relief. By the way, this may not be a negative thing for the borrowers. The same mechanism will provide you relief if the MCLR were to go up.

There Is a Silver Lining for Existing MCLR Borrowers

If you have taken a loan from SBI a couple of months back, you would have got loan at 9.15% (1 year- MCLR of 8.9% and spread of 0.25%). A new borrower will today get loan at 8.65% (1-year MCLR of 8% and spread of 0.65%). Notice the difference in spread. As I understand, it is not easy to change Spread in case of MCLR loans. You need to redo risk profiling to justify the increase in spread. Hence, in my opinion, spread becomes a constant and MCLR is a variable. Existing MCLR borrowers (say December 2016) have spread at 0.25% and the new borrowers (after January 1, 2017) have a spread of 0.65% on their home loans. Existing borrowers have locked in a lower spread. What does this mean? Suppose MCLR (for SBI home loans) stays at 8% for the next 12 months. After 12 months, loan interest rate for the old borrowers will be 8.25% (MCLR of 8% and spread of 0.25%) while the new borrower will still be at 8.65%. Who will be smiling then?

Hence, if you are an existing borrower (under MCLR and borrowed before January 1, 2017), it is not so bad. The benefit of lower MCLR will flow to you in the next few months (based on your interest reset). Moreover, given that you have a lower spread, you will be paying an even lower rate than those who borrow after January 1, 2017. New borrowers must realise that they will have to live with higher loan spread for the entire home loan tenure. This will surely abate some of the euphoria.

What Should You Do?

If your existing loan is already on MCLR, relax and do nothing about it. The benefit of MCLR cut will flow to you sooner or later.

If you are existing borrower under base rate regime, don’t expect any favourable treatment from banks. You can consider switch charges and make a decision accordingly. If you do not find the proposition too attractive, transferring the loan to a different bank is an option worth considering.