The Marginal Cost of Funds-Based Lending Rate is an internal benchmarking rate that indicates the minimum interest rate threshold below which financial institutions cannot lend funds. This mechanism of interest rate determination for funds lending became effective from 1st April 2016. Prior to the introduction of MCLR rate, the Reserve Bank of India followed the based rate system (which was introduced in 2010).
While MCLR brought transparency in lending rate determination, it still remained by far a flawed system, forcing the RBI to introduce a more transparent and responsive lending system. The new lending benchmark, better known as RLLR, integrates external reference to the key policy rate, i.e., repo rate set by the RBI. In view of that, the internal benchmarking system is set to be phased out over time for a progressive lending system.
Nevertheless, it still carries weightage for existing loans being serviced on MCLR-based lending, typically long-term advances like home loans. It is thus essential for borrowers of such advances to gain a detailed understanding of the lending system discussed below.
Everything about MCLR rate
Marginal Cost of Funds-Based Lending Rate is determined by a lender depending critically upon the remaining repayment tenure for a loan. The rate is linked to actual deposit rates as well. MCLR rate is thus determined based on the following four components:
- Marginal cost of funds
Marginal cost of funds refers to the average cost at which various deposits of similar maturities are raised during a given period before the review date. It has two different components – Marginal Cost of Borrowing (which accounts for about 92% of the cost) and Return on Net Worth (which accounts for about 8% of the cost).
- Operating costs
Operating cost signifies the expenses required to raise funds for the borrowers. The cost is calculated after excluding the service charges levied on a given loan.
- Negative carry on CRR (Cash Reserve Ratio) account
Negative carry on CRR is an occurrence when the return on Cash Reserve Ratio (CRR) balance is nil. This results when the actual return on CRR is effectively less than the cost of funds. It also impacts the SLR (Statutory Liquidity Ratio).
- Tenure premium
The cost of lending critically depends on the loan tenure. Loans with a longer tenure signify an increased risk for the lender. Thus, they recover the cost of this risk by charging a premium fee referred to as the tenure premium.
MCLR can also be considered as an internal reference rate for lenders to fix the rate they can charge on a home loan, loan against property, etc.
Under the new MCLR rate regime, the actual lending rates are determined after adding the element of spread to MCLR. Once the calculation is complete with a thorough inspection, the lending authorities announce their individual MCLR rates, which can be reset after a set duration, of say 6 months.
As directed by the RBI, lenders are required to publish their internal benchmark rates for different tenures on a monthly basis. The tenures or maturities under this regime include overnight, one month, three months, six months, one year, or any other tenure a lender desires to hold valid. For example, exact interest rates of MCLR-based home loans are published each month and accessible to users.
Borrowers too must be well-aware of what is MCLR, how it works, and how it can benefit them. For example, with the introduction of this benchmarking system, customers can now gain from the rate cuts made by the RBI as per the reset period for their loan.
Unlike the base rate or PLR (Prime Lending Rate) System, it transmits the changes brought about in the interest rate policies. In the previous regime, the borrowers were also deprived of certain benefits when RBI initiated repo rate cuts. A delay in the process thus cancelled out the ultimate motive behind rate cuts. The scenario was, however, reformed with MCLR-based lending as borrowers could enjoy early benefits of such rate cuts.
Nowadays, many financial institutions also provide pre-approved offers to existing customers to expedite the process of financing. These offers are available on home loans, loans against property, and several other financial products. You can check your pre-approved offer right away only with your name and contact details.
Read Also: Switch from Base Rate to MCLR Rate
Knowing every minute detail about what is MCLR rate simplifies your task of availing loans. Borrowers who might have availed loans before the introduction of this benchmarking regime can also switch their loans to the new system. Borrowers often switch home loans to a new lender for better interest rates. Similarly, they can change their loan from the base rate system to MCLR if they find it beneficial.
The cost of converting a loan from base rate to MCLR rate generally ranges between 0.5 to 0.6% of the total loan amount. If after paying the conversion charges, the loan EMIs get cheaper, a borrower can certainly go ahead with the MCLR-based lending system.