What is MCLR and How Does it Impact the Loan You are Taking

The Reserve Bank of India (RBI) regulates the banking sector across India. It imposes certain regulations to maintain healthy competition, ensure transparency and standardisation, and benefit the borrowers at large. Marginal Cost of Funds Based Lending Rate, or MCLR, is one such initiative that came into force in April 2016. If you are a borrower seeking funds, you should be aware of MCLR and how it affects the rate of interest on a loan. Let us delve deeper into understanding what MCLR is in a loan. 
 

What is MCLR?

MCLR means the minimum rate below which financial institutions are not allowed to lend to the borrowers, although there are a few exceptions to this. MCLR was introduced to regulate lending rates. Earlier, some financial institutions offered loans to their primary customers at the base rate or below that, while loans to other customers were offered at a higher rate. Before MCLR was introduced, the base rate was set entirely at the discretion of the lender and was based on its private internal policies.
 
Also Read: 10 Key Terms You Should Know Before You Apply for a Loan
 

Why Was MCLR Introduced by the RBI?

 

• The RBI introduced it to bring in transparency and offer the benefits of reduced rates to its customers.
• MCLR ensures a fair rate to all customers, discourages favouritism exhibited by lending institutions and avoids undue advantage being passed on to their primary customers.

 

What is MCLR Rate and How is it Determined?

 
Let us understand how MCLR is calculated and the factors that can affect it. MCLR is an enhanced version of base rates under which lenders are required to follow a risk-based approach to calculate it. It takes into account various components such as operating cost, tenor premium, the marginal cost of funds and negative carry on the mandatory Cash Reserve Ratio. Lenders are required to review and publish their MCLR of various maturities every month. To understand the preceding components in a detailed manner, refer to the subheads below:

Tenure Premium

The tenure of the loan plays a crucial role in establishing the cost of lending. The cost of lending varies depending on the length of the loan. If the borrower applies for a longer period loan, the credit risk is high. To offset the risk, financial institutions transfer the risk burden to the borrower by imposing a tenure premium. 
 
Financial institutions may publish MCLR, or say, an internal benchmark for the below-given maturities.
 

• Overnight MCLR
• One month MCLR
• Three months MCLR
• Six months MCLR
• One year MCLR
• The internal benchmark rate for the maturity period is deemed appropriate by the financial institution.

 

The Marginal Cost of Funding

The marginal cost of funds refers to the average rate of deposits that have similar maturity and that were raised during the particular time frame before the review date. The marginal cost of funds is reflected in the financial institutions' book under the outstanding balance category. 
 
The marginal cost of funds takes into account several factors such as the marginal cost of borrowing, return on net worth, and more. 
 

Operating Cost

Operating cost in MCLR refers to the cost involved in raising funds. However, this cost does not include expenses that were collected separately through service charges.
 

Negative Carry on Account of CRR

A negative carry on Cash Reserve Ratio (CRR) occurs when there is nil return on the CRR balance. When it comes to the Statutory Liquidity Ratio (SLR), the situation of negative carry arises when the cost of the funds exceeds the actual return. 
 
Also Read: Things To Keep In Mind Before Taking Multiple Loans
 

What is the Effect of MCLR on Loan Rates?

Since 2016, banks are required to spread the new interest rates based on the creditworthiness of the customer. However, an exception to this would be loans that are approved under government schemes and are required to follow a special, pre-determined rate of interest. The applicable rate of interest would be the MCLR on the date on which the loan is sanctioned.
 
Lastly, note that your credit score will impact the chances of getting a loan at the desired rate under the MCLR rate regime.
 

What is the Difference Between Base Rate and Marginal Cost of Fund based Lending Rate (MCLR)?

 Both the base rate and MCLR are based on the same principle, although there is a slight difference between them. To distinguish between these two rates, look at the table below:
 

Parameters	Base Rate	MCLR
Basis	The base rate is determined by the average cost of funds.	The MCLR is determined by the incremental, or say, a marginal cost of funds.
Calculation Approach	While calculating the base rate, the lender takes into account the profit margin, or say, a minimum rate of return.	MCLR is calculated after taking into account the tenure premium.
Influencing Factors	Base rate is influenced by the operating expenses and costs involved in maintaining the cash reserve ratio.	MCLR is influenced by the factors such as repo rates, cost of maintaining Cash Reserve Ratio (CRR), operating costs, and deposit rates.

 
Also Read: How to Improve Your Credit Score After A Loan Settlement?
 

To Conclude

The MCLR initiative by the RBI promotes transparency and assists in regulating interest rates. Borrowers can benefit if MCLR follows a downward trend, however, there is no guarantee for this to occur. It would be prudent to study the market scenario and seek guidance from your financial advisor before opting for it. Discuss the options with your lender to understand the pros and cons of switching to the MCLR regime and find out how much interest would be applied. If you are planning to apply for a new loan, check online marketplaces to compare the current MCLR rates of top lenders in the country.
 
Disclaimer: This post was first published on 16 March 2021 and has been updated for the latest information, freshness, and accuracy.