MCLR Rate Decoded: How Does This Bank Rate Shape Your Loan EMIs?

MCLR, short for Marginal Cost of Funds-based Lending Rate, was introduced by the Reserve Bank of India in 2016. It refers to the minimum interest rate that a bank must charge for a specific loan. Unless revised by the RBI, it creates a lower boundary for loan interest rates and remains exact for borrowers.

Learn about the different types of MCLR rates, their advantages, limitations and how it impacts your loans below.

Key Takeaways

• MCLR is the minimum interest rate below which banks cannot lend. 
• The 1-year MCLR is the most commonly used benchmark for home loans. 
• It ensures faster transmission of RBI repo rate changes compared to the base rate system.

What are the Different Types of MCLR Rates?

Financial institutions follow several types of MCLR rates based on the loan term to provide flexibility for various borrowing needs. 

• Overnight MCLR: Generally, considered for very short-term, single-day loans
• 1-month MCLR: Applied to ultra-short-term credit that requires quick repayment facilities
• 3-month MCLR: Typically preferred for short-term personal loans and working capital loans
• 6-month MCLR: Often linked to loans (personal or SME loans) with a medium-term tenure
• 1-year MCLR: Most frequently used benchmark for long-term retail loans, such as home loans
• 2-year MCLR and 3-year MCLR: Banks offer these rates less frequently, mostly ideal for longer loan terms. 

What are the Key Benefits of MCLR?

Transparency

With MCLR rates, banks can create a more transparent and well-structured way to determine the minimum interest rate for lending.

Responsiveness

MCLR adjusts to RBI’s monetary policy shifts much faster and more accurately than the earlier base rate system.

Cost Efficiency

In a declining interest rate scenario, MCLR loans often offer lower overall costs than loans under the previous base rate system.

Regular Rate Adjustments

Commercial banks consider reviewing their monthly MCLR to keep lending rates aligned with current market movements.

Limitations of MCLR

Changes in lending rates take effect only after the next reset period, not immediately. This is one of the key limitations of MCLR. Others include:

Partial Bank Control

Although MCLR is more transparent than the earlier base rate system, banks still have some flexibility in deciding the final lending rates.

Various Reset Schedules

The frequency of revising rates is not similar for every bank. It significantly varies between six months and one year.

What is the Difference Between MCLR and Base Rate?

How to Calculate MCLR Rate?

Banks use the following formula to calculate MCLR: 

MCLR =  MCOF + Negative Carry on CRR + Operating Cost + Tenor Premium

Here's an explanation of each component of the formula:

• Marginal Cost of Funds (MCOF): This includes the cost of deposits and borrowings. A specific formula is used: (92%* Marginal Cost of Borrowing) + (8% * Return on Net Worth)
• Negative Carry on CRR: Banks hold 4% of deposits with the central bank as the Cash Reserve Ratio (CRR). It does not earn interest. So the negative carryforward is considered a cost in the funds-based lending rate since it lowers the bank's ability to earn from those holdings.
• Operational Costs: This cost refers to the expenses that are needed to run the operations of banks, such as employee salaries, administrative expenses, office space and system maintenance charges. These costs are essential and should not be confused with the service charges collected from customers.
• Tenure Premium: It refers to a risk-based charge, generally applicable to loans with longer terms. Higher tenures come with higher credit risk, which is why a tenure premium is applied. 

What is the Impact of MCLR on Borrowers?

Lower Costs for Borrowing

When the RBI cuts the repo rate, borrowers stand to gain, as banks are required to lower their MCLR, reducing interest rates on home, personal and other loans.

Transparency in Loan Pricing

With MCLR, loan pricing becomes more transparent because lending rates move in line with the bank’s funding costs, limiting the scope for arbitrary interest rate changes.

Here is an example which will help you understand the impact clearly! 

For instance, your loan is associated with the 1-year MCLR, and your bank lowers the rate. You can not find any reflection of this cut immediately. The EMI will only reflect this after the annual reset date. 

It makes MCLR less responsive than RLLR (Repo-linked Lending Rates). Still, most banks adopted this framework as it is better than the earlier base rate system.

Final Word

The MCLR framework was introduced to address the shortcomings of the base rate system and offer borrowers fairer loan pricing. Understanding its advantages, limitations, calculation method and impact can help you make practical borrowing decisions.

However, borrowers should also be aware of the reset period and keep track of their bank’s monthly MCLR rates to remain updated about potential EMI changes.