Understanding MCLR Based Home Loans: All You Need to Know

In the world of home financing, the Marginal Cost of Funds based Lending Rate (MCLR) has been a pivotal metric since its introduction by the Reserve Bank of India (RBI) in April 2016. This system was introduced to replace the old base rate system to ensure fair interest rates to borrowers as well as banks. If you’re considering a home loan, understanding how MCLR can affect your loan choices is crucial. This comprehensive guide will cover everything you need to know about MCLR-based home loans.

• MCLR
• How Does MCLR Work?
• MCLR vs. Base Rate
• RBI Guidelines On MCLR
• Types of MCLR Rates
• Impact on EMI
• Benefits of MCLR for Borrowers
• MCLR vs Repo Rate
• Comparison with Other Benchmarks

MCLR Meaning

MCLR in banking stands for Marginal Cost of Funds-based Lending Rate. It is the minimum interest rate that a bank can charge on loans. MCLR is intended to reflect the marginal cost of funds, meaning it considers the cost incurred on new deposits and borrowings. The formula for MCLR calculation includes four components: the marginal cost of funds, negative carry on account of the cash reserve ratio (CRR), operating costs, and tenor premium.

How Does MCLR Work?

MCLR is an internal benchmark or reference rate for the bank. Every bank calculates its MCLR rate monthly by considering the marginal cost for funds (primarily the interest rate at which banks borrow money), return on net worth (according to capital adequacy norms), and operational expenses. The actual lending rates are determined by adding a spread to the MCLR which covers the bank’s risk.

The general formula for MCLR is as follows:

MCLR = MCF + CRR Cost + Operating Costs + Tenor Premium

• MCF (Marginal Cost of Funds): Calculated as the weighted average rate of all deposits, borrowings, etc.
• CRR Cost (Negative Carry on Account of CRR): Reflects the return forgone on cash reserve ratio maintained with RBI.
• Operating Costs: A fixed percentage that covers the bank’s operational expenses.
• Tenor Premium: Varies depending on the loan maturity period.

MCLR interest rates are reset at intervals agreed upon at the time of the loan sanction. Depending on your lender and the loan agreement, this could be once every six months or annually. This reset clause means that your loan’s interest rate will adjust and align with the current MCLR plus the spread at these intervals.

Suggested read: Lowest Home Loan Interest Rate

Difference between MCLR & Base Rate

MCLR	Base Rate
Minimum lending rate below which banks cannot lend.	The rate at which banks cannot lend below is introduced to ensure transparency and fairness in lending.
Introduced to enhance the transmission of monetary policy and ensure more transparent lending rates by banks.	Introduced to bring transparency to the rates offered by banks and ensure that the banks cannot lend below a certain rate.
Includes marginal cost of funds, CRR cost, operating costs, and tenor premium.	Based on the average cost of funds, excluding the current repo rate and not necessarily responsive to immediate market changes.
Highly responsive to RBI policy changes due to the inclusion of repo rate and marginal cost.	Less responsive to RBI policy changes compared to MCLR.
Can be reset as often as monthly, enhancing responsiveness to changes.	Typically reviewed quarterly or semi-annually, leading to slower rate changes.
Aims to improve internal efficiency and transparency in bank loan pricing.	Served to improve transparency over previous systems but lacked responsiveness to RBI rate changes.

RBI Guidelines On MCLR

1. The RBI mandates that the actual lending rates on loans and advances be reset at least once a year, based on the MCLR to which the loan is linked.
2. The interest rate on fixed-rate home loans remains unchanged by fluctuations in MCLR.
3. The marginal cost of funds calculation incorporates considerations of deposit balances and additional borrowing.
4. Banks are allowed to specify interest rate spreads and credit risk premiums over and above the base MCLR, but these must remain constant through the life of the loan agreement, unless the borrower’s credit assessment undergoes a substantial change as agreed upon in the loan contract.
5. Certain types of loans, such as loans against deposits, loans to banks’ own employees, and loans linked to a market-determined external benchmark, are exempt from being linked to MCLR.
6. Existing borrowers on the base rate system have the option to switch to MCLR-based pricing, albeit banks can levy a reasonable fee for the switch, based purely on the costs involved.

Suggested read: Repo Rate Effect on Home Loans

Types of MCLR Rates

Banks may offer various MCLR rates depending on the loan tenure, which could range from overnight rates to one-month, three-month, six-month, and one-year rates. Longer tenure MCLR, like the one-year rate, is typically used for home loans. The choice of the reset period can significantly affect your repayment amount.

Impact on EMI

If the MCLR rate increases when it is time for your loan’s interest rate reset, your loan’s interest rate will also rise, leading to higher EMIs (equated monthly installments) or an extended loan period. Conversely, if the MCLR rate drops, you might enjoy lower EMIs or a shorter loan duration, depending on the terms of your contract with the bank.

Benefits of MCLR for Borrowers

The primary advantage of MCLR is its transparency and responsiveness to RBI policies. Since banks must align their rates with the current MCLR, any reductions in the lending rate by the RBI are supposed to be passed to the customers. This system aims to improve the transmission of policy rates into the lending rates of banks, thereby making them more dynamic.

Choosing Between Fixed and Floating Rates

When opting for an MCLR-linked loan, you’ll typically be choosing a floating rate loan. While fixed-rate loans provide certainty regarding EMI amounts throughout the loan period, floating rates offer the benefit of reduced interest rates when the MCLR drops. However, this also means your EMIs can increase with a rise in MCLR. Therefore, your decision might depend on your financial stability and risk tolerance.

MCLR vs Repo Rate

Aspect	MCLR (Marginal Cost of Funds Based Lending Rate)	Repo Rate
Definition	Minimum lending rate below which banks cannot lend.	Rate at which RBI lends money to commercial banks.
Purpose	To enhance transmission of monetary policy and ensure more transparent lending rates by banks.	To control inflation and regulate the economy by managing the liquidity in the banking system.
Components	Marginal cost of funds, operating costs, negative carry on account of CRR, and tenor premium.	Not applicable as it is a direct rate set by the central bank.
Impact on Loans	Directly affects the interest rates on loans like home loans, auto loans, and personal loans offered by banks.	Indirectly influences consumer interest rates through monetary policy; affects the cost of funds for banks.
Set By	Individual commercial banks based on guidelines provided by RBI.	Set by the Reserve Bank of India (RBI).
Frequency of Change	Banks review MCLR monthly, which then affects the floating rate loans.	Repo rate is reviewed by the RBI during its bi-monthly monetary policy meetings.
Economic Focus	Aimed at improving the internal efficiency and transparency of bank loan pricing.	Primarily used as a monetary policy tool to regulate overall liquidity and stability in the financial system.

Comparison with Other Benchmarks

As of October 2019, RBI mandated that all new floating rate personal or retail loans (housing, auto, etc.) should be linked to external benchmarks like the RBI repo rate, rather than MCLR. This move was to enhance the transparency and efficiency of the rate transmission process. Existing borrowers on MCLR have the option to continue until repayment or switch to the new system as per their convenience.

Final Thoughts

For prospective homebuyers, deciding on the type of home loan interest rate—whether MCLR-based or linked to another benchmark—requires careful consideration of your financial situation and future outlook. With its dynamic adjustment feature, MCLR-based loans can be attractive during periods of monetary easing, where you can benefit from falling interest rates. However, it’s essential to stay informed about the economic conditions and RBI policies that influence these rates, to manage your loan effectively and avoid any financial strain due to rate hikes.

In summary, while MCLR has brought certain improvements to the lending landscape, aligning your home loan choice with your financial goals and market conditions will help you make the best decision. Always consult with a financial advisor or your bank to understand the detailed implications of these choices on your long-term financial health.

FAQs about MCLR-Based Home Loans