MCLR – Meaning, Calculation, MCLR vs Base Rate

The Marginal Cost of Funds Based Lending Rate (MCLR) was introduced in April 2016 to help borrowers availing various loans (including home loans) benefit from the Reserve Bank of India's (RBI) rate cut. It replaced the base rate structure, which had been in place since July 2010. This new rate system ensures that your lender cannot charge you interest rates beyond the margin prescribed by RBI. So, understanding the workings of the MCLR will help you repay your loans affordably. Keeping this is in mind, let us understand what MCLR means and the recent developments in this space.

Why did RBI Introduce MCLR?

Commercial banks were reluctant to change their individual lending rates and deposit rates with periodic changes in repo rate. Which means, there was a significant delay between RBI's repo rate change and the transmission of that change to the borrowers of the banks. The purpose of altering the repo is realized only if the banks are replicating the action with their individual lending and deposit rates. Thus, in adopting the MCLR regime, RBI aims to

• Bring the much-needed transparency in financial institutions while determining their interest rates
• Pass the benefits of reduced interest rates to customers ASAP
• Ensure availability of loans to customers that is fair to both, customers as well as the lender

Understanding MCLR:

MCLR is the minimum interest rate that a bank can lend at. Under the MCLR regime, banks are free to offer all categories of loans on fixed or floating interest rates. The actual lending rates for loans of different categories and tenors are determined by adding the components of spread to MCLR. Therefore, the bank cannot lend at a rate lower than MCLR of a particular maturity for all loans linked to that benchmark. However, certain exceptions can be made when allowed by the RBI.

How to Calculate MCLR?

MCLR is a tenor-linked internal benchmark, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan. The MCLR is based on a range of factors in order to broaden the use of this tool.

The four major elements of MCLR include the following:

• Tenor premium:

  It is the premium charged by the banks for the risk associated with lending for higher tenors. Tenor is the amount of time left for repayment of the loan. Higher the duration of the loan, higher will be the risk. In order to cover the risk, the bank will shift the load to the borrowers by charging an amount in the form of premium. Tenor premium is not specific to a loan class or borrower, but is uniform across all types of loans.

• Marginal Cost of Funds:

  Marginal cost of funds (MCF) is calculated by taking into account all the borrowings of a bank. Banks borrow funds from various sources, including fixed deposits (FD), savings accounts, current accounts, equity (retained earnings), RBI loans, etc. The rates of interest on these borrowings is used for the calculation of MCF. MCF includes Marginal cost of borrowing and Return on net worth. Marginal Cost of Borrowings takes up 92% while the Return on Net Worth accounts for 8%. This 8% is equivalent to the risk of weighted assets as denoted by the Tier I capital for banks.

• Negative Carry on CRR:

  CRR or Cash Reserve Ratio is a proportion of the bank's fund that banks in India are supposed to submit to the RBI in form of liquid cash, mandatorily. It is accounted for negatively as this money cannot be used by the bank to make any income and does not earn interest. Under MCLR, banks are given certain allowance for that, called Negative Carry on CRR, which is calculated as under:

  Required CRR A — [marginal cost(1 - CRR)]

• Operating cost:

  Banks incur various expenses for raising funds, opening branches, paying salaries and so on. All operating costs associated with providing loan products are included in operating costs. However, cost of providing services, which are recovered by way of service charges, are not included.

MCLR Formula with an example

The Marginal Cost of Funds Based Lending Rate (MCLR) is calculated using operating costs, cost of funds, and tenor premium. Here is a simple formula to calculate the MCLR: -

MCLR=Marginal Cost of Funds+Operating Costs+Tenor Premium+Spread

For instance, if the marginal cost of funds is 7.5%, operating costs are 0.2%, the tenor premium is 0.1%, and the spread (bank's profit margin) is 0.3%, the Marginal cost of funds lending rates would be:

7.5%+0.2%+0.1%+0.3%=8.1%

7.5%+0.2%+0.1%+0.3%=8.1%. This rate determines the minimum interest rate for loans banks offer to borrowers.

MCLR vs the Base rate

Though there are various differences between the two, given below are the major ones- Base rate was set by the RBI and MCLR is set by the banks themselves based on their business strategy. This means that borrowers can benefit for competitive interest rates and get loans at a cheaper rate.

Base rate loans interest rate will be updated once in a quarter. However, MCLR loans interest rate will be published on monthly basis.

The loan tenure was not taken into account when determining the base rate. In the case of MCLR, the banks are now required to include a tenor premium. This will allow banks to charge a higher rate of interest for loans with long-term horizon.

What is MCLR Rate?

So, what exactly is what is MCLR rate? The marginal Cost of Funds Lending Rate was first introduced by the Reserve Bank of India in the year 2016 to determine the minimum interest rate banks can lend to borrowers. It replaced the earlier base rate system and aimed to make lending rates more responsive to changes in the policy rates set by the RBI. Here is a detailed explanation of MCLR: -

• Dynamic Interest Rates:

  MCLR is a dynamic lending rate that allows banks to adjust their interest rates according to their marginal cost of funds. It considers factors like repo rate, the price of funds, operating expenses, and the desired profit margin.

• Components of MCLR:

  The MCLR rate consists of several components: - Marginal Cost of Funds: Reflects the cost of acquiring one additional unit of funds. Operating Expenses: Banks' operational costs and administrative expenses. Tenor Premium: Reflects the higher cost associated with longer loan tenures. Negative Carry on Cash Reserve Ratio (CRR): Banks have to hold a certain percentage of their deposits in cash with the RBI, which doesn't earn any interest. This cost is factored into MCLR.

• Tenor Linked:

  MCLR rates are linked to the tenor of the loan. That means they can vary for different loan periods.

• Transmission of Policy Rates:

  Marginal cost of lending rate ensures faster transmission of changes in RBI's policy rates to the end borrowers, making the lending rate structure more responsive to market conditions.

• Transparency:

  MCLR provides transparency in calculating lending rates, allowing borrowers to understand how their interest rates are determined.

• Review Period:

  Banks are required to review and publish their MCLR rates at least once a month, ensuring that the lending rates stay in line with market conditions.

What is the Base Rate?

The Base Rate is the minimum lending rate set by commercial banks in India, below which they cannot lend to their customers. It replaced the Benchmark Prime Lending Rate (BPLR) system in July 2010. Here's a detailed explanation:

• Benchmark Rate:

  The Base Rate is the benchmark lending rate for all loans disbursed by banks, except loans given to the priority sector, where different rates might apply.

• Calculation:

  The Base Rate is calculated based on the bank's cost of funds, which includes factors like the cost of borrowing from other sources, operational expenses, and the required profit margin.

• Adjustment:

  Banks can set their Base Rate, but it must be reviewed at least once every quarter. Changes in the Base Rate are influenced by various economic factors, including the Reserve Bank of India's monetary policy decisions, inflation rates, and overall market conditions.

• Transmission of Policy Rates:

  One of the key objectives of the Base Rate system was to ensure that changes in the Reserve Bank of India's policy rates are transmitted effectively to the end borrowers. When the RBI reduced policy rates, banks were expected to reduce their Base Rates, making borrowing cheaper for consumers and businesses.

• Uniformity:

  Base Rate promoted uniformity in lending rates. It ensured that similar categories of loans from different banks were priced around the same level, enhancing transparency and fairness in the lending process.

This is represented in the table below-

Cost of fund consideration for base rate loans calculation is not standard and banks consider the older cost on deposit to arrive at the cost of fund. However, in the case of MCLR loans, the cost of fund is the deposit rate applicable for that particular month.

loan pricing system is more transparent for MCLR than for base rate, because of the computing formula.

MCLR considers unique factors like the marginal cost of funds instead of the overall cost of funds. The marginal cost takes into account the repo rate, which did not form part of the base rate. Hence, it is an improved version of the base rate.

Repo rate & MCLR based loans

Borrowers under the MCLR system benefit from a cut in the repo rate. But, the interest rates can increase if the RBI increases the repo rate. MCLR has an effect on loans which are borrowed at floating rates of interest only. Loans taken on fixed rates are unaffected by the change in MCLR. Borrowers who would like to switch to MCLR based loan should take into account the amount charged as fees by the bank for initiating the change. Few banks have waived off switch charges to benefit their customers, few others charge a fixed amount as conversion fees, while select banks compute the fees as a fixed percentage ranging from 0.5% to 2% of the loan sanction amount. Thus, when considering the cost of making the switch, these fees should be considered along with the related charges.

What are the deadlines to disclose MCLR?

As per Reserve Bank of India (RBI) guidelines, banks must review and disclose their Marginal Cost of Funds Based Lending Rate (MCLR) at least once a month. This ensures that lending rates align with market conditions and policy rate changes made by the RBI. Banks must publish their MCLR rates on their official websites and other prominent platforms accessible to the public. Regular disclosures maintain transparency and enable borrowers to make informed decisions based on the prevailing lending rates.

Conclusion

Understanding MCLR is fundamental for anyone seeking a loan in India. It empowers borrowers to make informed decisions, enabling them to secure loans at competitive rates. By staying aware of market changes and regularly comparing rates, borrowers can leverage the MCLR system to their advantage, ensuring affordable and stable lending rates for their financial needs.