Understanding MCLR and its Effects on Home Loans

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On April 1, 2016, the Reserve Bank of India introduced the Marginal Cost of Fund Based Lending System (MCLR) as the new rate system for commercial banks and other money lending institutes in India to grant loans.

Any new borrower that wishes to apply for home loan post April 2016 will be compulsorily granted a loan as per the MCLR system. The introduction of MCLR has affected many loan facilities in India, with a particularly high influence on the home loans.

The Need for MCLR

Prior to its introduction, all the banks and other non-banking financial companies (NBFCs) used to follow the base rate system for determining their loans’ interest rates. Different banks had different base rates as the minimum benchmark to grant loans to the customers. However, the base rate system had certain loopholes because of which certain loan providers were offering preferential treatment to certain clients in terms of their home loan interest rate. As a result, a lot of customers experienced bias in their home loan repayment in the case of repo rate changes by the government.

What Are Repo Rates And Why Are They Important?

A repo rate is the interest rate at which the Reserve Bank lends credit to most commercial banks. Repo rates are important tools used by the Reserve Bank to change the influx or efflux of credit in the Indian economy. For instance, if the Reserve Bank decreases the repo rates, it makes it easier for commercial banks to borrow more from the RBI, and pass it on to the end-user customers coming to them for availing loans. This move helps increase the credit flow in the economy, as the end-users are in more money. Alternately, if the RBI increases the repo rate, it ultimately leads to a decrease in credit flow in the economy. However, with the earlier base rate system, the end-user public could not efficiently enjoy the benefits of repo rate changes as efficiently due to the slow implementation by the SBI and other nationalized banks. As a result, ultimately it was the common public that suffered. However, the MCLR was introduced with an aim to change these discrepancies.

MCLR in Home Loans

Unlike the base rate system, an MCLR can surely pass the benefit of repo rate changes to the end-users. This is because the MCLR system can change quickly in response to any RBI dictate with respect to the repo rates. Also, it is now mandatory for banks to set different MCLRs as per the loan tenure. This could be either overnight, monthly, quarterly, or yearly. Thus, suppose a home loan borrower avails a home loan at quarterly MCLR, then his/her home loan interest rate might change after every three months, which, in turn, will affect his/her EMI amount after this period. Likewise, if the borrower manages to avail a home loan at yearly MCLR, he/she will continue paying the yearly EMI as per the decided interest rates, in spite of any change in repo rates by the RBI within that year.

The RBI has stated the following formula to calculate your MCLR –

Marginal cost of funds = (92% x Marginal cost of borrowings) + (8% x Return on net worth).

However, factors like the cash reserve ratio of the bank, operational costs, and the total tenor premium also influence the MCLR.

The MCLR facility benefits the maximum for home loans as compared to other types of loans. This is because, generally, home loans have a comparatively long tenure. Any change in home loan interest rates could drastically increase or decrease the loan repayment installment amount over this long tenure. This, in turn, could significantly disrupt the financial planning of a borrower that he/she has made for the home loan repayment. In extreme cases, it might even put a considerable financial strain on the borrower. However, all of this could be avoided with an MCLR in home loan. Even if the repo rate rises in the future, the borrower will continue enjoying the benefit of his original MCLR, by paying lower EMI installments. Other benefits of MCLR include-

  • Improved transmission of policy rates between RBI and commercial banks

  • Increased transparency in determining interest rates as per your eligibility

  • Increased competitiveness between banks to maintain sufficient credit and provide affordable loan providing facilities to the end-users.

Things to Keep In Mind about MCLR on Home Loans

  • The benefits of MCLR can only be availed on floating interest rates on home loans, and not fixed interest rates.

  • Most commercial banks still hold the power to add spread to the MCLR, even though they are set lower than the base rates.

  • Borrowers who are serving the loan tenures for home loans taken at previous base rates are offered a choice to convert to MCLR. However, they may have to pay some conversion fee for the same. If you are someone that has borrowed a loan at base rates and want to switch to an MCLR, here are a few tips on how you can reduce the MCLR on your outstanding loan balance-

  • Request your loan provider to extend the tenure of your home loan

  • Opt for pre-payment option on your home loan to nullify the effect of the interest rate difference

  • Request to transfer your home loan to a fixed-rate after a thorough and suitable cost-to-benefit analysis.

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