What Is the Impact of MCLR Hike on Personal Loan Rates?

Last Updated: 14 Oct 2024

MCLR, which stands for Marginal Cost of Funds based Lending Rate, is a benchmark banks use to establish their minimum interest rate. This rate is determined by considering factors such as the bank’s cost of funds, operational expenses, and desired profit margin. Banks employ MCLR to calculate the interest rate on various loans, including home loans. Typically, the interest rate on a home loan is fixed at a certain percentage above the MCLR, which is known as the ‘spread.’

When the MCLR fluctuates, the impact of MCLR hike on Personal Loan rates is directly tied to it. Consequently, the Equated Monthly Instalment (EMI) amount will either increase or decrease based on the direction of the MCLR movement. In general, a lower MCLR result in lower interest rates and, therefore, reduced EMIs for borrowers. Conversely, a higher MCLR leads to higher interest rates and, subsequently, higher EMIs for borrowers.

It is crucial to understand that while MCLR plays a significant role in determining the interest rate on a home loan, it is not the sole factor. Other variables, such as the borrower’s credit score and the duration of the loan, also influence the final interest rate. To learn what is the impact of MCLR hike on personal loan rates, keep reading below.

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What Exactly Is MCLR?

MCLR, established by the Reserve Bank of India (RBI), serves as an internal reference rate for banks. Its purpose is to determine the minimum interest rate applicable to various types of loans. The ultimate lending rate includes additional components such as the risk spread and premium charged by banks.

In simple terms, MCLR represents the lowest rate at which banks can offer loans to their customers. The RBI introduced the MCLR method in 2016 to facilitate borrowers accessing Auto Loans and Home Loans, ensuring a smoother transmission of the Central Bank’s Repo rate. The Repo rate denotes the rate at which the Reserve Bank of India lends funds to different banks.

Moreover, between MCLR vs EBLR, the banks have replaced the former with the later to make the lending process easy. Although the difference between MCLR and EBLR is huge, the banks are following EBLR so that the lending rate directly goes to the bank policies.

Effects of MCLR

The impact of MCLR hike on Personal Loan rates are as follows:

Regulation in Rate Changes

Before the introduction of the MCLR system, the RBI observed that banks were quick to raise interest rates on floating-rate loans when the RBI increased rates. However, they could have been more active in reducing rates when the RBI lowered them. The MCLR system was implemented to break this pattern and encourage banks to adjust their rates more promptly in accordance with changes in cost conditions.

Effect on spread

The RBI also observed that banks would initially offer loans at low-interest rates with very narrow spreads, which appeared attractive to customers. However, after a few months, the banks would increase the spread without any valid reason. This led to an unjustifiable rise in interest rates for the customers, even if the base rate remained unchanged. In contrast, under the MCLR system, banks are obligated to determine a spread at the time of loan sanctioning, and this spread can only be augmented if there are changes in the individual’s credit profile. Additionally, banks are required to reset interest rates at least once a year on the loans.

Transparency

The MCLR generally enhances customer transparency, providing clearer pricing for floating-rate loans.

Effect on banks

The implementation of MCLR will impact banks’ margins, requiring them to publish their monthly interest rates for a minimum of five different tenures. Furthermore, banks will face restrictions on the spread they can charge customers throughout the loan term.

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Final Words

When facing an increase in MCLR rates leading to higher EMIs, you can adopt specific measures to mitigate the impact. Two effective strategies are extending the loan tenure to reduce EMIs and making part-prepayments to lower EMIs.