MCLR in Home Loans

MCLR is abbreviated as the marginal cost of funds-based lending rate. It defines the process used to determine the minimum home loan rate of interest. As per the guidelines issued by the Reserve Bank of India, the financial institutions cannot offer interest rates on home loans which are lower than the marginal cost of funds-based lending rate. 

The MCLR method was introduced in the year 2016 by the Reserve Bank of India. It has replaced the base rate system that was introduced in 2010. Thus, the renewal of credit limits and sanctioning of loans is done as per MCLR norms.

What are the RBI Guidelines About MCLR?

The following are the guidelines issued by the Reserve Bank of India about MCLR-

  • The fixed-rate home loans will not be affected by the MCLR.
  • Deposit balances and other borrowings are considered while computing the marginal cost of funds.
  • Housing finance companies and other financial institutions are required to publish the marginal cost of funds-based lending rate for different tenures.
  • MCLR as on the sanction date of the floating rate home loan will stand the same till the next reset date.

How to calculate MCLR?

MCLR is calculated based on the loan tenure i.e. the duration an application takes to repay his/her loan. This tenure-linked benchmark is internal. The financial institutions determine the actual lending rates by adding the elements spread to this. Then they publish their MCLR rates after careful inspection. 

The four main elements of the MCLR are given below:

Tenure premium: The cost of lending varies from the loan duration. The higher the loan duration, the higher will be the risk. To cover the risk, the financial institution will shift the load to the borrowers by charging an amount in the form of a premium. This premium is known as the Tenure premium.

The marginal cost of funds: It is the average rate at which the deposits with similar maturities were raised during a specific period before the review date. This cost will reflect in the books of the lender's in the form of outstanding balances. The MCLR has several components like the Return on Net Worth and the Marginal Cost of Borrowings. 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.

Operating Cost: The financial institutions 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, the cost of providing services, which are recovered by way of service charges, are not included.

Negative carry on account of CRR: Negative carry on the CRR (Cash Reserve Ratio) takes place when the return on the CRR balance is zero. Now, this will further impact the mandatory Statutory Liquidity Ratio Balance (SLR) – reserve every commercial bank must maintain. It is accounted negatively as the lenders cannot utilize the funds to earn any income nor gain interests.

How is MCLR different from Base Rate?

  • The base rate was set by the RBI, whereas the MCLR is set by the financial institutions based on their business strategy. It means that the borrowers can get benefit from the competitive interest rates and get home loans at a cheaper rate.
  • The base rate interest rate is updated once in a quarter. However, the MCLR loan interest rate will be published monthly.
  • The loan tenure was not considered while determining the base rate. In the case of MCLR, the banks are now required to include a tenure premium. This will allow financial institutions to charge a higher rate of interest for loans with a long-term horizon.
  • The cost of fund consideration for base rate loan 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 funds is the deposit rate applicable for that month.
  • The 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 considers the repo rate, which did not form part of the base rate. Hence, the MCLR is an improved version of the base rate.