The full form of MCLR is Marginal Cost of Funding-based Lending Rate. This is a type of lending rate which is charged by banks. It is a minimum interest rate at which a bank lends, below which, the bank is not allowed to lend. MCLR was established in 2016 by the RBI as a replacement to the old system of Base Rate of interest on loans. With the establishment of the MCLR system, all previous base rate linked loans and credit exposures are required to migrate to MCLR. The RBI has set up a facility to link the base rate for loans given by banks to the MCLR system starting 1st of April, 2018. This will benefit borrowers who have borrowed on base rate.
MCLR is derived from the following factors:
- Marginal cost of funds
- Tenor premium (which pays off the risk on long-term loans)
- Operating expenses
- Cost of Cash Reserve Ratio (CRR)
The traditional base rate system is derived from the average cost of funds and minimum rate of return. MCLR reflects the Repo Rate set by the RBI. A repo rate is a rate at which commercial banks borrow money from the RBI in case they run out of funds. This means that lower the repo rates, lower will be the interest rate at which commercial banks float loan to the end-customers. Therefore, MCLR helps in passing on any changes in policy rates set by the RBI to the banking customer.
As mentioned above, the MCLR system has been successfully put into effect from this financial year and will be applicable on loans. This implies that any loan taken (car or home loans) will be based on the MCLR system post march 2018. As directed by the RBI, the MCLR applicable on any type of loan has to be in a 1-year rate or of a lower tenure. Banks have an option to choose either a six month or a standard 1-year MCLR. Banks also have the option to add a small percentage of interest over the MCLR for any of the loans offered. This implies that the interest rate of the loan will be reset as per the benchmark MCLR on an annual basis, provided it is a floating rate loan or a fixed loan less than 3 years in tenure.
Let us illustrate this with a simple example. Bank A has set its 1-year MCLR at 9.2%. You have decided to take a home loan on June 2016 at a floating rate of interest. The bank decides to add a small percentage of interest equivalent to 25 basis point. Thus, the final rate of interest offered by bank A to you will be 9.45%. Taking this into consideration, if the MCLR slumps to 9.1% next financial year, the interest rate offered by Bank A will comes down to 9.35%.
