What Is The Meaning Of MCLR?

Ever wondered how banks and financial institutions decide the interest rate on funds for users? The RBI plays a crucial role here by setting a fixed internal reference rate for banks, known as MCLR rate. It is further used by lending institutions and banks that fall under RBI.

Let’s understand the concept of MCLR rate in detail through this blog.

What is MCLR Rate?

MCLR full form is Marginal Cost of Funds Based Lending Rate, it refers to the minimum interest rate below which no bank or financial institution shall lend any loans. To determine the minimum interest rate, banks consider various factors such as cost of funds, operating cost, profit margin etc. Interest rates for various loans such as home loans are calculated by using MCLR. The home loan interest rate is set up as a fixed percentage above MCLR rate, which is known as ‘spread’. If the MCLR changes, the interest rate of loans linked to it also fluctuates. This fluctuation brings an impact in monthly EMIs. 

What is the Aim and Impact of MCLR Rate?

The MCLR has a direct impact on the interest rates on loans:

• If MCLR is lower, the interest rate will also fall leading to lower EMIs. 
• A higher MCLR leads to high interest rates and higher EMIs. 

Any change in the MCLR can bring an impact in the borrowing cost for individuals or businesses by affecting their spending and investment decisions. 

MCLR aims to: 

• Brings transparency in banks and financial institutions while determining interest rates.
• The availability of loans are ensured for customers, being fair for both customers and lenders.
• Customers are benefited by reduced interest rates.

What are the Components of MCLR  Rate & How to Calculate MCLR?

The MCLR comprises four main components:

Tenor Premium: This accounts for the risk associated with the length of the loan. Longer-term loans typically carry higher risks, and to cover this, banks charge a premium based on the loan tenor.

Marginal Cost of Funds (MCOF): This represents the average rate at which the bank has raised deposits of similar maturities during a specific period before the review date. It includes:

• Marginal Cost of Borrowings (92%): The primary component reflecting the cost of funds.
• Return on Net Worth (8%): Reflects the cost associated with the bank’s Tier I capital, which accounts for the risk-weighted assets.

Operating Costs: These are the expenses related to managing and providing loans, excluding those costs covered by service charges. They reflect the bank’s operational expenditure involved in loan issuance.

Negative Carry on CRR (Cash Reserve Ratio): This occurs when the return on the CRR balance is zero. Negative carry arises when the return on the mandatory reserves is less than the cost of funds. This situation impacts the Statutory Liquidity Ratio (SLR), as banks cannot use these reserves to generate income or earn interest, leading to a financial disadvantage.

The formula to calculate MCLR is: Tenor premium + MCOF + operating cost + negative carry on CRR. 

What is Base Rate? 

The base rate is the minimum interest rate set by a bank below which it cannot lend, except in specific circumstances allowed by the Reserve Bank of India (RBI). Introduced in July 2010 by the RBI, it replaced the earlier Benchmark Prime Lending Rate (BPLR) system to bring greater transparency and fairness to loan pricing.

The base rate serves as a benchmark for determining the interest rates for various types of loans, such as home loans, personal loans, and business loans. Factors that influence the base rate include the bank’s cost of funds, operating expenses, and a reasonable profit margin.

However, in April 2016, the RBI replaced the base rate with the Marginal Cost of Funds-based Lending Rate (MCLR) to further enhance transparency and ensure that changes in policy rates are transmitted more effectively to borrowers. The MCLR system considers the marginal cost of funds, including repo rate changes, making loan pricing more dynamic compared to the base rate.

Difference Between MCLR Rate and Base Rate

Following are a few major differences between MCLR and Base rate:

• Risk-Based Approach: MCLR is a risk-based method for setting the final lending rate. Unlike the base rate, which uses the overall cost of funds, MCLR considers the marginal cost of funds.
• Repo Rate Inclusion: MCLR calculations factor in the repo rate, which was not included in the base rate. This allows for a more accurate reflection of current borrowing costs.
• Comprehensive Interest Rates: Banks must include all types of interest rates incurred in mobilizing funds when calculating MCLR.
• Tenor Premium: Unlike the base rate, MCLR incorporates a tenor premium, charging higher interest rates for long-term loans to account for increased risk.

What is the MCLR Monthly Deadline?

Banks have the flexibility to offer loans at either fixed or floating interest rates. They are required to disclose their MCLR or internal benchmark by specific deadlines, which can vary in duration, such as overnight, one month, three months, or one year, depending on the bank’s preference.

The lending rate for any loan cannot be lower than the MCLR. However, there are exceptions for loans not linked to MCLR, including loans secured against deposits, loans for bank employees, certain government schemes like Jan Dhan Yojana, and fixed-rate loans with terms longer than three years.

Understanding MCLR is crucial for navigating loan interest rates effectively. It ensures transparency and adjusts loan rates based on the marginal cost of funds, offering a fairer system for both banks and borrowers. Keeping abreast of MCLR changes can help manage your loan costs better.