What is MCLR: Effects and How to Combact them

Dinesh Maheshwari April 20, 2019

What is MCLR in Loan?

If you’ve been considering whether to take a loan, you may have come across the term MCLR. If you’ve been wondering what is MCLR in loan terminology, we’ll discuss it in detail below. MCLR stands for Marginal Cost of Funds based Lending Rate. First introduced on 1st April2016, this is rate has replaced the previous base rate system, in order to set the interest rates for loans. Essentially, MCLR is the minimum interest rate below which a bank or cannot lend, with exceptions in certain cases.The main objective of MCLR is to address the issues of the base rate system, by helping borrowers to avail loans by benefiting from the RBI’s rate reduction. Prior to MCLR when banks and financial institutions would lend on base rates, their main customers would receive unfair advantages over other borrowers. For example, if the baseline rate of lending was set at 7%, some financial institutions would lend to their premier customers at 7% or less; for regular borrowers, the interest rate would be a higher figure, around 10-12%As the base rate is determined by the internal policy of financial institutions, this resulted in a huge financial loss. As a matter of fact, even after interest rates were reduced, it took a significant amount of time for these financial institutions to reduce their lending rates and pass the benefits to their borrowers.Therefore, MCLR aims to bring forwarded transparency among the lending sector, with regards to determining interest rates. It also aims to ensure the benefits of reduced interest rates are passed on to customers, while also maintaining fairness for both customers and lAdditionally, as per MCLR mandate, banks must declare their interest rates rates every month, be if ove1361 year and 2 year rates of interest. As a borrower, one can find out more about MCLR lending rates from a bank’s website.

How is MCLR Different?

MCLR is an improvement from the standard base rate of lending. It takes a risk-based approach to determine the lending rate for borrowers, by considering factors such as marginal cost of funds, as opposed to the overall cost of funds. Marginal costs also consider repo rate, which were not part of the base rate.In order to calculate MCLR, banks and financial institutions must incorporate all other interest rates incurred during the mobilization of funds. Earlier, the loan tenure wasn’t considered an important factor; now, with MCLR, financial institutions should include a tenure premium. Therefore, they can levy a higher interest rate for loans with longer repayment tenures.

Effects of MCLR Implementation

Post the implementation of MCLR, interest rates will be determined on the basis of risk of individual borrowers. Earlier, when RBI introduced the repo rate, it took a long time for banks to implement the same in their lending rates for customers. As per MCLR, banks must banks will be required to update their interest rates as soon as there is a change in the repo rate.

How to Calculate MCLR

Calculating MCLR is done in tandem with the loan repayment tenure. In essence, this tenure-linked parameter is internal, and it determines the actual lending rates by including the elements to this tool. As a result, banks disclose their MCLR after a thorough review. This process also applies to loans of different maturities, be it monthly or according to a pre-announced cycle.The four primary factors of MCLR comprise of the following: 1. Marginal Cost oThe average rate using the deposits having similar maturities raised during a specific time prior to its review date is known as marginal cost of borrowing. This reflects in the bank’s books via their outstanding bMarginal cost of borrowing is comprised of several other factors such as marginal cost of borrowings and return on net worth. Marginal cost of borrowings accounts for 92%, and return on net worth takes 2. Tenure For various loans, there is uniformity in the tenure period for the residual tenure. Basically this means that the tenure premium is not restricted to a borrower or loan ca3. Negative Carry on AccountNegative carry on CRR (Cash Reserve Ratio)occurs when the return on CRR balance is nil. Essentially, this is when the actual return is lower than the cost of funds. This also impacts the Statutory Liquidity Ratio balance, a reserve that all commercial banks are required to ma4. OperatiOperational expenses cover the cost of raising funds excluding the costs recovered separately via service charges. Therefore, operating cost is linked to providing the loan.

The Effects of hike in repo rate on MCLR

For the first time in four years, RBI has increased the repo rate. As a result, this hike will solidify interest rates, which will also affect the MCLR rate. This will cause banks and other financial institutions to hike their MCLR rates which will subsequently spike up interest rates and EMI. However, it should be noted that MCLR is only linked with floating interest rates, and not fixed interest rates.

How to Combat Effects of MCLR

As MCLR rates are causing EMIs to skyrocket, there are measures one can take to diminish its impact. These two strategies to implement include opting for a longer loan repayment tenure to reduce EMI burden, as well as making a part pre-payment to further reduce them

For loans availed after 1st April 2016, they are automatically linked with MCLR. However, if you have availed a loan prior to this date and it is linked to the base rate system, you can always opt to switch to MCLR. However, it’s important to note that if your loan is near completion of its repayment tenure, then stick to the current base rate and avoid switching over to MCLR.

Dinesh Maheshwari

April 20, 2019

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