At the start of the new financial year, banks changed the way they calculate interest rates offered on loans. This was in response to a Reserve Bank of India directive that required banks to base their loan interest rates on the MCLR (Marginal Cost of fund based Lending Rate) method. The new MCLR method replaces the earlier base-rate method that banks used to calculate the interest rates on loans offered to borrowers. In the following sections, we will discuss some key aspects of the MCLR and how it is affecting the borrowers.
What is MCLR and how is it calculated?
The Marginal Cost of fund based Lending Rate or MCLR comprises four components – the marginal cost of funds, the CRR (cash reserve ratio), tenure premium and operating costs.
Marginal Cost of Funds: This is the difference between the marginal cost of borrowing and the returns received by the bank on its net worth.
CRR: Cash reserve ratio or CRR is an RBI-specified minimum fraction of total customer deposits that the bank has to keep deposited with the central bank i.e. Reserve Bank of India at all times. The CRR is considered as a negative carry because it cannot be utilised by the bank for investment purposes or generating returns.
Tenure Premium: This also adds to the rate at which a commercial bank lends money to borrowers by taking into account the bank’s existing commitments to service loans with longer tenure.
Operating Costs: The operating costs included in the MCLR calculation include key costs such as the cost of funds and the costs associated with providing the loan to the borrower.
Based on the above, the one year MCLR formula for a bank = Interest rate offered by the bank on 1 – year term deposit + CRR + Tenure Premium + Operating Costs
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MCLR Requirements as per Reserve Bank of India
As per the RBI directive, banks have to publish a minimum of 5 MCLR-based lending rates. The mandatory ones are – overnight, 1 month, 3 month, 6 month and 1 year. Banks are however free to publish data for additional lending rates for longer tenures. Ideally, the rates offered should be reviewed on a monthly basis, however, till March, 2017, banks have the option of just performing quarterly reviews. The maximum period that a single interest rate can persist for a specific loan has been capped at 1 year.
How Will Bank Fix Your Loan Interest Rate
As per the new RBI-specified MCLR norms, the banks will add a spread to the MCLR rate based on key factors such as your credit profile. Thus your credit history and by extension your credit score will continue to play a key role in determining the interest rate that you will be charged by the lender. So make sure you check your credit score before applying for a new loan to gauge your chances of success. Depending upon your creditworthiness, the spread will range between 25 to 60 basis points i.e. 0.25% to 0.6% + the applicable MCLR.
Key Effects of the MCLR Regime on Home Loans
Home loans feature a tenure that is much longer than any borrowing instrument and therefore the periodic interest rate changes may affect the absolute payout made by an individual on the home loan. As per the current MCLR rules, the home loans interest rates may be revised by banks either on a half yearly or yearly basis. Currently the MCLR-based loan rates are slightly (approximately 5 basis points) lower than those based on the old base rate method, however, this may change based on changes in the CRR, marginal cost of funds as well as other market factors.
In case of individuals who already have an existing home loan that is linked to the earlier base rate regime, the old system will remain in effect until the loan is renewed or repaid. Such individual borrowers may however be able to negotiate a transfer of their existing home loan to the MCLR system on the basis of mutually accepted terms with the lender.
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Key Effects of the MCLR Regime on Car Loans
The situation is similar for car/auto loans as well, because the current MCLR rates are slightly lower than the previous base rate-based interest rates. Additionally, in case of a floating rate car loan, the applicable interest rate would also be revised on either a half yearly or a yearly basis. Though the base rate calculation would still be applicable in case of existing auto loans, banks may allows a transfer to the MCLR system based on specific terms and conditions.
Conclusion
It has only been a short time since banks have affected the change in calculations and it will be some time before the long term effects of this change are apparent. In the short term, the MCLR-based system has resulted in slightly lower interest rates in case of various types of loans including car loans and home loans.