MCLR - Its effect on interest/EMI on loans

It is a general perception that since the introduction of MCLR (Marginal Cost of Funds based Lending Rate), the rate of interest on loans/EMIs are coming down. An understanding of the computation of Base Rate and MCLR may help us appreciate the facts in a better manner.

EMI is a component of three factors — Amount of loan, Repayment period, and Interest on Loan. Keeping the first two constant, any changes in the interest on loan shall increase or decrease of EMI payable on our loans.

Every bank, while arriving at the lending rates like Base Rate takes into account four components namely, 1) Cost of Funds (COF), 2) Negative carry on CRR/SLR, 3) Operating Cost, and 4) Reasonable Profit Margin.

To be precise, banks accept deposits at a particular interest and use the money of the depositor for lending (after retaining some portion of deposits in cash (CRR) and investing some portion in approved securities (SLR) as per RBI guidelines. The interest paid on the deposits (COF) of the banks as such is a major component while deciding the lending rates.

Banks’ lending rates were linked to Base Rate till April 1, 2016. Base Rate is the minimum rate at which banks lend to its borrowers. While computing the cost of funds for arriving at BR, interest rate on Fixed Deposits used to be considered, without taking current and savings deposits. This led to a slightly skewed computation of lending rate. Further, BR was also not factoring the cost of borrowings from RBI. As such, the change in repo rates (Rate at which banks borrow from RBI) had little impact on the reduction in BR.
During 2016, RBI has reduced repo rates several times with a hope that the reduction in the repo rates would be passed onto the borrowers by the banks with reduced lending rates. However, the banks did not do so. This led the RBI to issue a Master Direction DBR.Dir.No.85/13.03.00/2015-16 dated March 03, 2016 (updated up to March 29, 2016), directing the banks to completely change the system of arriving at the Lending Rates based on MCLR.

Under MCLR, cost of funds will be arrived on the basis of cost of new (incremental) deposits and borrowings. Presently, most banks have reduced the rate of interest on deposits. Further, RBI has been reducing the Repo rates at regular intervals or keeping it constant. Since banks are mobilising deposits at lower interest rates and also cost of borrowing is coming down, it would effect in bringing down the MCLR and consequently reducing the EMIs.

RBI directed all banks to compulsorily link the lending rates to MCLR with effect from April 1, 2016. Now, the borrowers who have taken loans linked to BR are paying higher Interest/EMI vis-à-vis those who have availed the loan linked to MCLR.

To extend the benefit of reduced interest under MCLR to those borrowers who have taken the loan before April 2016, RBI has issued guidelines to banks to allow the existing borrowers to switch over to MCLR-linked rates with mutually acceptable terms. The guidelines are also very clear that such an option is not to be treated as foreclosure and no charges whatsoever be levied by banks on such a switch over.

One more advantage of switching over to MCLR is that as per RBI directive, the MCLR prevailing on the date of first disbursement, shall be applicable till the next reset date. MCLR despite being a floating rate provides the comfort of a fixed rate of interest. This means that MCLR is fairly a stagnant rate when compared to BR. Having read this, if you have decided to switch over to MCLR, call on your bank, complete the formalities and enjoy the benefit of reduced interest/EMI.

(The writer is Asst Professor [Senior Scale] at Manipal University, Bangalore)