A Guide To MCLR

The MCLR (marginal cost of funds-based lending rate) was introduced in the year 2016 to assist you as a borrower to avail distinct loan benefits from the RBI (Reserve Bank of India). This replaced structure of the base rate, which was in place since 2010. This new interest rate system ensures your lender cannot levy a rate beyond a prescribed margin by the RBI. So, by understanding the MCLR workings, you can repay your loans quite easily. Keeping this idea in mind, let’s understand what’s MCLR and the crucial developments in this vertical. 

Why MCLR was introduced?

Commercial banks were heavily reluctant about the changes in the individual deposit and lending rates with periodic changes in the repo rate. This means, there was a considerable delay between the RBI’s repo rate as well as transmission of this change to borrowers of banks. The purpose of altering the repo is realised just if banks are replicating the action with individual deposit and lending rates. Thus, RBI adopted MCLR basically owing to the below reasons – 

• Bring the much-required transparency in banks and financial institutions while deciding their rate of interest. 
• Passes the advantages of the lowered rate of interest to you as a customer immediately. 
• Make sure the availability of a loan to you as a customer is fair to you and the lender, both. 

Understanding the MCLR

Kotak MCLR rate, ICICI bank MCLR or MCLR of any other lender refers to the minimum rate of interest that a lender can lend at. As per the MCLR regime, banks are totally free to provide all kinds of loans on floating or fixed rate of interest. The actual rate of lending for loans of distinct categories as well as tenures is decided by adding spread components to MCLR. Thus, the financial institution cannot lend at an interest rate below the MCLR of a specific maturity for all credit options linked to that of a benchmark. But a specific exception can be done by permitted by the Reserve Bank of India. 

Computing the MCLR

MCLR refers to the tenured attached with the internal benchmark. This means the interest rate is decided internally by the bank based on the time period left for loan repayment. The MCLR depends on a range of parameters to broaden the usage of this factor. The 4 crucial elements of MCLR are – 

Tenure premium

This is the premium levied by banks for risk linked with lending for higher tenures. Tenure refers to the time left for loan repayment. The higher the loan duration, the higher would be the involvement of risk. To cover up the risk, the lender often moves the load to borrowers by levying an amount as a premium. Tenure premium is not dependent on the loan class or the borrower but is usually uniform across all kinds of loans.

The marginal cost of the fund

The marginal cost of fund is computed by taking into account all bank borrowings. Banks borrow funds from distinct sources involving savings accounts, fixed deposits, current accounts, RBI loans, equity, etc. The interest rates on such borrowing are utilised for MCF computations. MCF involve marginal borrowing cost and return on the net worth. Marginal borrowing cost takes basically up to 92 per cent while the return on net worth is 8 per cent. This 8 per cent is equal to the risk of weighted assets as indicated by capital on tier 1 for banks. 

Negative carry on CRR

CRR also called the cash reserve ratio refers to the proportion of a bank’s fund that Indian banks are required to submit to the Reserve Bank of India in form of liquid cash. This is accounted for negatively as this fund cannot be utilised by the bank to make income and does not earn any interest. As per the MCLR, banks are provided with a specific allowance for this known as negative carry on the CRR.

Operating expense – Financial institutions incur distinct expenditures for raising funds, paying salaries, opening branches and others. All operating expenses linked with providing loan products are included in your operating expenses. However, the expense involved in providing services is recovered through service charges.

MCLR vs base rate

While there are distinct differences between the two, mentioned here are the important ones – 

· Base rate is set by RBI and MCLR is fixed by financial institutions depending on their business strategy. This means, you as a borrower can benefit from competitive rates and get loans at a lower rate. 

· Base rate loan rate will get updated once every quarter. However, the MCLR loan rate is published monthly. 

· Loan repayment tenure is not factored in when deciding the base interest rate. In the case of MCLR, banks are required to include a tenure premium. Doing so would permit financial institutions to levy a heavy interest rate for loans with a long-term horizon. Representation of the same is done in a tabular form – 

Base rate computation	MCLR computation
Fund cost	Cost of maintaining CRR
Operating expenditures	Tenure premium
Cost of maintaining CRR	Operating expenditures
Profit margin	Marginal fund cost

Fund cost consideration for the base rate loan computation is not at all standard and the financial institutions tend to factor in the older deposit cost to compute the fund cost. However, in the case of an MCLR loan, the fund cost is the rate of deposit applicable for that specific month. 

·  Loan pricing system is considerably more transparent for the MCLR than for the base rate owing to the computing formula. 

· MCLR considers specific unique parameters like marginal fund cost in place of overall fund cost. The marginal cost factors in the repo rate, which does not form a part of the base rate. Hence, this is an ameliorated version of the base rate. 

Repo rate and MCLR linked loans

Borrowers under MCLR benefit from a massive cut in repo rate. However, the rate of interest can enhance if the Reserve Bank of India enhances the repo rate. Generally, MCLR has an effect on loans, which are borrowed at a floating interest rate only. Loans availed on fixed interest rates are not affected by changes in the MCLR. Borrowers who like to switch to the MCLR-based loan must consider the thorough amount levied as charged by the bank for initiating the change.