What is marginal cost of funds-based lending rate or MCLR?

[ecis2016.org] Discussed in this article are the key aspects of the marginal cost of funds-based lending rate (MCLR), which served as a benchmark for banks to set their interest rates

With an aim to offer borrowers with a higher level of transparency and cost effectiveness, the banking system has from time to time introduced various rate-setting methodologies, based on which loan interest rates are set and calculated. With the same objective, the Reserve Bank of India (RBI), in April 2016, introduced the MCLR rate regime.

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What is MCLR full form?

MCLR stands for marginal cost of funds-based lending rate. Since April 1, 2016, the MCLR has acted as the internal benchmark rate of banks for extending all kinds of loans, including home loans.

However, because of its failure to meet its key objective of offering transparency and cost effectiveness to the end-user, the RBI, in 2019, replaced the MCLR rate regime with the repo rate regime. Nevertheless, since home loans taken between April 1, 2016 and September 30, 2019, are still linked with the MCLR rate, it makes sense for borrowers to have a clearer understanding about the MCLR regime and decide if they want to switch their home loans to the repo rate regime.

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What is MCLR meaning?

Banks charge an interest from the borrower on the loans they extend. These loans include home loans, loan against property, gold loans, etc. According to rules set under banking regulations, they have to set the interest rate, based on a rate-setting benchmark approved by the RBI.

Under the banking regulations, banks not only have to offer transparency in rate setting, they also have to quickly pass on the benefits of rate cuts, effectuated by the RBI, to the end-users, i.e., loan borrowers. Since the RBI felt that banks were failing to meet these two objectives, because they used internal lending benchmarks in setting interest rates, it replaced the base rate regime with the MCLR rate regime.

The MCLR was introduced by the RBI in April 2016, to make sure banks were quick in passing on the benefits of interest rate cuts to the borrowers, something which was not happening under the BPLR regime. Since the base rate and BPLR regimes were internal lending benchmarks, banks had a lot of control over it and invariably, failed to pass on the benefits that they themselves enjoyed when the RBI reduced the repo rate and offered them funds at a lower interest.

The MCLR rate regime replaced the previous base rate system, which was operational since 2010. Prior to that, banks lent to customers using the Benchmark Prime Lending Rate (BPLR) system.

Note here that MCLR is the rate below which banks will not lend funds to a borrower. However, based on various factors, like credit risk and tenure of the loan, they tweak the ‘spread’ between the MCLR and the actual interest rate. This means that the actual interest rates for loans will be determined by adding the component of spread to the MCLR rate. This basically amounts to the fact that if a bank’s MCLR rate is 6%, it can charge an 8% interest from the borrower, by keeping the spread at 2%.

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Components of MCLR rate regime

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The MCLR rate regime, which is closely linked to the actual deposit rates, is built on four key components:

Marginal cost of funds or MCF: The marginal cost of funds is the average rate at which the deposits with similar maturities were raised during a specific period before the review date.

Negative carry on account of cash reserve ratio (CRR).

Tenure premium: The cost of lending varies depending on the period of the loan.

Operating costs: It is the cost of raising funds.

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Resetting of MCLR rates

Under the MCLR regime, banks reset the MCLR rates at periodic intervals – overnight, one month, three months, six months and one year.

In case of home loans, the MCLR is typically based on a one-year MCLR rate. This means that even if the RBI reduced the repo rate thrice in a year, the bank will change the MCLR rate only once in a year. With MCLR, banks were required to readjust the rate of interest monthly or yearly, depending on this resetting clause in your loan document. Financial institutions are mandated to review and publish MCLR of different maturities on a monthly basis.

MCLR rate and fixed-rate loans

Fixed rate loans are exempted from being linked to the MCLR benchmark, for determining interest rate. The MCLR rate is applicable only on floating rate loans. However, fixed-rate loans with tenors of up to three years are also priced according to the MCLR rate.

What kind of loans are linked with MCLR?

Under the MCLR rate regime, banks can offer all categories of loans at floating interest rates. Several types of loans used to be linked with the MCLR benchmark, including home loans.

Difference between MCLR rate and Base Rate

Although both, the Base Rate regime and the MCLR rate regime, were internal lending benchmarks, they were different from each other in the way they treated the calculation of marginal cost. In the base rate system, the marginal cost used to be calculated by taking a simple average of the interest rates spent on deposits. However, under the MCLR rate regime, interest rates were calculated according to the marginal calculation of the cost that the bank incurred, to arrange the deposits. Unlike the base rate system, the RBI-determined repo rate is included in the marginal cost in the MCLR regime. Another difference between base rate and the MCLR rate is that unlike base rates, MCLR rates are revised every month, too.

Exemptions under the MCLR regime

The MCLR regime was applicable on all loans, barring car loans and personal loans. Loans that fall under government schemes, where the banks were directed to charge a certain rate of interest, were also exempt from the MCLR rate regime. The MCLR regime was applicable only on banks and not on housing finance companies (HFCs) or non-banking finance companies (NBFCs). So, between 2016 and 2019, HFCs and NBFCs used their own internal lending benchmark to lend loans and not the MCLR.

Failure of MCLR regime

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The MCLR is a tenor-linked internal benchmark. This means, the interest rate is decided internally by the lender, depending on the period left for the repayment of a loan. Even though banks had to take into account the changes in the repo rate, while calculating the MCLR rate, they failed to pass on the benefits of the RBI’s rate cuts, under the MCLR rate regime. This was a similar problem under the base rate and the BPLR regime.

Also, because of the ambiguities in the reset clause, borrowers found the MCLR rate regime confusing and complicated.

In the case of home loans, banks invariably kept a one-year reset clause. This meant that even if the RBI lowered its repo rates multiple times in a year, the borrower’s EMI would go down only after the bank re-adjusted it, as mentioned in the agreement.

Scrapping of MCLR regime and introduction of repo rate regime

An internal panel set up by the RBI, to examine various aspects of the MCLR system in 2018, recommended linking of bank’s lending rates to external benchmarks. Following this, the government started the process to replace the MCLR rate regime with the repo rate regime, to improve policy transmission. Under the new regime, banks have to link their lending rates with benchmarks like treasury bill rate, certificate of deposit rate or the RBI’s repo rate.

In a circular issued on September 4, 2019, the RBI said it had observed that due to various reasons, the transmission of policy rate changes to the lending rate of banks, under the prevalent marginal cost of funds-based lending rate framework, had not been satisfactory. Subsequently, banks linked their loans with an external benchmark, from October 1, 2019, after the Reserve Bank passed an order in this regard.

Note that while existing borrowers whose loans were sanctioned between April 1, 2016 and September 30, 2019, still had their debt linked to the MCLR, they have the option to switch to the new repo-linked lending rate (RLLR). All new borrowers are now offered loans linked only to the repo rate.

Should you switch your loan to repo-rate linked loans from MCLR?

Since the process of transmission is slow in the case of the MCLR rate, borrowers will get the benefit of rate cuts by the RBI at a slower speed. “In the case of MCLR-based loans, banks have to factor in their cost of deposit, operating cost, etc., apart from the repo rates, while calculating rates. Hence, MCLR rate-based loans are always likely to have slower transmission of policy rate changes,” explains Paisabazaar.com chief executive officer and co-founder, Naveen Kukreja.

Also, in a low interest rate regime, such as the current one, it makes much better sense to switch your loan from the MCLR rate regime to the repo rate regime.

Example: SBI MCLR rate vs repo rate loan

State Bank of India, in May 2021, reduced the home loan interest rate to 6.7%. On the other hand, at the same time, SBI’s one-year MCLR rate, on which its home loan is linked, stood at 7%. This means a borrower will have to pay higher EMI, if his loan is linked with the MCLR.

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However, borrowers must also be careful about the quick transmission since it is a two-way alley. “Borrowers need to keep in mind that repo-rate linked loans can work against them during a rising interest rate regime. These loans will witness faster increase in their interest rates, in case of repo rate increases by the RBI,” Kukreja cautions.

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