MCLR in Home Loan

The interest rate is one of the most important components of a loan, especially in the case of a high-value loan that lasts for 2 decades or more; the home loan. There is not a single borrower who does not want to benefit from a lower home loan interest rate. In April 2016, the Reserve Bank of India introduced a new guideline called MCLR under which borrowers could gain the benefit of cuts or reductions in home loan interest rates in real time. Let’s try to find out all about what is MCLR in a home loan.

What is MCLR?

'Marginal Cost of Funds Based Lending Rate or MCLR is simply the lowest interest rate offered by banks, housing finance companies and other lenders when a borrower takes out a loan. Typically, lenders cannot provide home loan interest rates which are lower than MCLR. Despite this, lenders can make some exceptions if they receive permission from the Reserve Bank of India.

As such, MCLR is basically the internal benchmark or the reference rate for all financial institutions. It defines the process that determines the minimum interest rate on home loans. The MCLR system was introduced in 2016, replacing the existing base rate system of 2010. Credit limit renewals and loan sanctioning is done according to MCLR norms since the introduction of MCLR.

What is MCLR rate in Home loan?

MCLR is linked to the repo rate and lenders’ fund costs. In case the repo rate changes, it impacts the floating interest rate on home loans. So, if the lender reduces the MCLR, the floating interest rate on the home loan will also reduce. While the reduced rate and MCLR will not affect the equated monthly instalment or EMI that you are paying, the loan tenure is definitely affected.

How is MCLR calculated?

To calculate MCLR, it is important to first consider all the sources from which banks borrow funds. Banks typically borrow funds from various sources such as savings accounts, current account, fixed and recurring deposits and so on. The borrower can refer to the interest rate of these borrowing sources to calculate the marginal cost of borrowing. Remember that the source of funds for banks is not just borrowing; it also entails equity.

As per the formula defined by the RBI, MCLR home loan is calculated as under:

MCLR = Marginal borrowing cost x 92% + return on the net worth x 8%

According to RBI guidelines, banks are also mandated to maintain a minimum cash reserve ratio or CRR of no less than 4%. The bank does not earn any interest on this deposit. Under MCLR, it is possible for banks to obtain a certain amount of allowance called Negative Carry on CRR. Banks must also consider and take care of the operating costs. Remember that the bank has its own expenses which include the cost of raising funds, paying salaries to employees, opening multiple branches of the bank for customer convenience and so on. These charges cannot be billed to the customer. There is also a discount or tenor premium. The tenor is simply explained as the reset period for interest rates and is directly proportional to the reset period. As such, if the tenor is high, so is the reset period.

Therefore MCLR home loan depends largely on the tenor premium, the operating costs borne by the bank, the marginal cost of funds and the negative carry on CRR.

Final word:

MCLR offers the much-needed respite of lowered interest rates that borrowers require, but only borrowers with a floating interest rate on home loans can benefit from it. MCLR does not affect the fixed interest rate on home loans. It is important to remember that the bank considers deposit balances as well as other borrowings while it computes the marginal cost of funds.