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What is MCLR rate and how it effects loans?

Published On Feb/25/2024

The MCLR, or Marginal Cost of Funds-Based Lending Rate, replaced the older base rate system for setting interest rates on April 1, 2016, as directed by the RBI. Although borrowers who took loans before this date are still governed by the previous base rate and BPLR (Benchmark Prime Lending Rate) systems, they have the option to transition to the MCLR rate if they find it more advantageous.

Here is everything that you need to know about MCLR and how it affects loan rates.

What is MCLR?

The Marginal Cost of Funds-Based Lending Rate (MCLR) is a benchmark set by the Reserve Bank of India (RBI) that helps banks decide the lowest interest rate they can offer on various loans like home loans, personal loans, business loans etc.

Banks must not lend at rates lower than the MCLR, or they'll be penalised by regulatory authorities. Yet, there are rare situations where they can lend below this rate, but only with special permission from the RBI. This rate is calculated based on the additional cost banks incur to lend each rupee to borrowers.

Why was MCLR introduced?

The central bank shifted banks to the MCLR system because the older base rate system wasn't working well. The RBI wanted a system that responded better when it made changes to interest rates, which is crucial for managing the country's economy.

Before MCLR became mandatory, banks used different methods to set their rates. Some looked at average costs, while others used marginal costs. This inconsistency made things confusing.

So, the RBI introduced the MCLR system for a few main reasons:

  • To make sure changes in the RBI's rates quickly affect the rates banks offer.

  • To make how banks set loan rates more transparent.

  • To ensure both banks and customers get fair interest rates.

  • To help banks compete better and support the country's economic growth.

Also Read: Top Tips To Lower Your Home Loan Interest Rates

How does the MCLR influence the EMIs?

The MCLR system is designed to make borrowers, and businesses trust banks more. By making how banks decide on loan rates clearer, more people and businesses feel confident using banks for loans.

Additionally, with the MCLR system, when the RBI makes changes to its rates, like lowering them, it means people's loan monthly payments (EMIs) can go down faster. This helps the RBI make better decisions to manage the country's money effectively.

How is MCLR calculated?

Calculation Breakdown: The MCLR is figured out using this simple formula:

MCLR = MCOF + Negative Carry on CRR + Operating Costs + Tenor Premium.

MCOF: This is the cost banks face when they get money from various places like deposits. It depends on the interest rates linked to these sources.

Negative Carry on CRR: Here, banks figure out the cost of holding some of their money with the RBI, which doesn't earn interest. It's based on a set rate and the cost of getting funds.

Operating Costs: This is what it costs a bank to run day-to-day expenses, like paying staff or rent.

Tenor Premium: Banks add more to the MCOF for longer loans, recognising that longer loans can be riskier. This extra bit is based on how long a bank's financial obligations last.

Summing up

The adoption of the new system allows banks to provide loans linked to various external benchmarks such as the RBI repo rate, Government of India treasury bills, or other rates set by Financial Benchmarks India Pvt. Ltd. The RBI's efforts to enhance transparency and efficiency within the banking sector are noteworthy. These reforms are anticipated to stimulate retail consumption and elevate the overall business sentiment in the country.