What exactly is MCLR?

Banks used the base rate as the benchmark rate for lending until March 31, 2016.

It was the interest rate below which banks could not extend loans to potential borrowers. The Reserve Bank of India, India’s banking regulator, introduced the MCLR, or Marginal Cost of Fund-based Lending Rate, in 2016. 

It meant that all loans extended and credit limits renewed after April 1, 2016, would be based on the MCLR. It has become the bank’s internal benchmark rate for extending loans. It is also known as a floating interest rate regime.

For those who don’t know, the MCLR or Bank of Baroda MCLR is directly related to the Equated Monthly Instalments (EMI) of the home loan taken out by homebuyers. It wouldn’t be wrong to say that the MCLR rate determines the monthly EMI payments made by borrowers. 

Banks such as BOB may also set a spread that is higher than the Bank of Baroda MCLR. Banks will make this decision based on your credit history. The spread will be determined by credit risk and term. If the borrower is not prone to loan default, the MCLR spread will be lesser. A basis point is equal to one-hundredth of a percentage point.

What Really Influences MCLR Rate?

The MCLR is determined by a number of factors, which are weighed together to determine the interest rate. The following are the main factors that influence Kotak MCLR calculation:

Marginal Cost of Funds: It is the most distinctive feature of the MCLR regime and is determined by factors such as the interest rate on savings accounts, term deposits, short-term interest rate or repo, and return on net worth, among others. The marginal cost of funds is the marginal cost of borrowing as well as the return on net worth. 

No Return on Cash Reserve Ratio (CRR): Under the Bank of Baroda MCLR interest regime, banks and financial institutions receive no interest on money reserves held with the RBI (Reserve Bank of India).

Operating expenses: The operating costs are also important in determining the MCLR. These are the ongoing operating expenses borne by banks. The cost of providing the loan product, as well as the cost of raising funds, is included in the operating cost. 

Tenure bonus: It means that longer-term loans can be charged higher interest rates.

What exactly is the main difference between the MCLR and Base Rate systems

How marginal cost is calculated is the critical difference between the Base Rate system and the Bank of Baroda MCLR. The base rate was calculated by taking a simple average of the interest rates paid on deposits. However, under the new system, interest rates are calculated using the following criteria:

  • The marginal calculation of the cost incurred by the bank in arranging deposits.
  • The repo rate is now included in the marginal cost, whereas the Base Rate system did not. It means that the new interest rates are directly related to the RBI’s changes in repo rates.
  • Banks take minor interest rates into account when calculating costs.

Why are banks taking so long to pass on the benefits to customers?

There is a widespread belief that when the repo rate is reduced, banks do not immediately pass those savings on to customers. The reason for this is the banks’ ‘Reset Period’ clause. It varies between banks and ranges from six months to one year. For example, the State Bank of India (SBI) has a one-year reset period. This period is usually specified in the loan agreement.

In other words, banks can use the reset period to affect changes in their EMIs. The shorter the reset period, the better it will be when the rate is reduced. 

Is switching your home loan to an MCLR-based regime beneficial for you?

How Kotak MCLR is calculated is what differentiates between the Base rate system and the MCLR. The base rate was previously calculated by taking a simple average of interest rates, and it limited the scope of any change in interest rates once decided.

However, because Kotak MCLR rates are linked to Repo rates (determined by the RBI), your home loan EMI bill is expected to fall if rates are reduced. The RBI revises the REPO rates every quarter of the fiscal year. When interest rates are reduced, banks pass the savings on to customers in the form of lower interest rates. 

Existing home loan Borrowers can ask their banks to tie their loans to the MCLR. This may be a good option for them because Kotak MCLR is typically lower than the base rate on home loans. However, before making a switch, one should always conduct extensive research and verification. Borrowers should think twice before making this decision because a home loan linked to the MCLR cannot be reversed to the base rate. If you plan to make this switch, make sure you understand the associated fees and charges. The charge schedule differs between banks. It may incur some fees from the customer’s end, and it is not always advantageous.

Within the same bank, switching from base rate to MCLR: If the difference between what you are paying and what the bank is now offering as MCLR is significant, it makes sense to switch. Also, in cases where the end date of the home loan is not near. An existing loan with an outstanding amount of Rs 20 lakh at 10.75% is switched to MCLR at, say, 9.55%. If you are in the base rate or even the BPLR (benchmark base lending rate) regime, switching to the Bank of Baroda MCLR can bring down interest rates. What you could do is ask your banker to calculate and inform you how much interest can be saved by switching from the base rate to the MCLR, and then make your decision.

Changing a loan from a base rate to an MCLR with another bank (refinancing): Look into refinancing if your bank is offering a high home loan interest rate (Kotak MCLR plus spread). Refinance the loan with a bank that offers a low-interest rate of around 9.5 per cent. However, before refinancing your loan, compare and shop around for offers, then shortlist the best ones. Before deciding to transfer your loan, make sure you consider all associated charges such as transfer fees, legal fees, and so on. Processing fees may apply, which many banks waive during the holiday season. In any case, banks are not permitted to charge foreclosure or full repayment fees. Other fees may include legal fees, mortgage payments, and so on. Remember that the bank may ask you to purchase a home loan insurance plan, which is not required. Instead, in addition to any existing insurance, insure the loan with pure term insurance.