Seeking a Loan? Welcome to the new interest rate regime from April 2016. There has been a lot of buzz in the news about this system to calculate interest rates for loans. We here, have made an attempt to explain the same to you in an easy manner.
What is the new interest rate regime that we are talking about?
Till 31 March 2016, banks were using the base rate as the benchmark rate to lend. From April 1, 2016, RBI has mandated banks to use a new system to calculate the interest rates for loans called ‘Marginal Cost of funds based Lending Rate’ or MCLR.
What is MCLR and how is it calculated?
MCLR stands for Marginal Cost of Funds based Lending Rate. MCLR is the new benchmark lending rate at which banks will now lend to new borrowers.
The main components of MCLR calculation are:
Why the old system of base rate has been replaced?
To understand, we need to know the term “repo rate”.
When banks need money, they approach RBI and the rate at which banks borrow money from the RBI by selling their surplus government securities to the Central bank is called REPO Rate. Repo rate is used by monetary authorities to control inflation. In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
Now, coming back to Base rate system. It was introduced by RBI in July 2010 to ensure that banks can not lend below a certain benchmark and that the changes in interest rate policy are effectively transmitted to the bank customers.
However, policy transmission could not become very effective as banks adopted various methods in calculating their cost of funds. Under the erstwhile system, the banks were slightly slow to change their interest rate in accordance with Repo Rate change by the RBI. It is evident from the fact that whenever RBI has cut interest rates (for e.g. by 125 basis points), banks have lowered their base rate by only few basis points (e.g. 50-60 basis points)
Banks have been giving one excuse or the other for not reducing lending rates. In case of rate cuts by the Reserve Bank, banks could always say that even though the cost of fresh borrowing has gone down, they have legacy deposits for which the interest rate remains high. There was nothing beyond a point that RBI could do to ensure quick transmission of interest rate cuts.
To counter this, RBI has introduced MCLR so that banks link their lending rates to marginal funding costs (cost of fresh or incremental borrowings). Hence, if the bank cuts the rates on deposits, it will automatically have to transmit the cut in deposit rates to lending rates. By cutting the deposit rates, the bank brings down its marginal cost of funds because it can raise deposits at a lower interest rate.
So, the rationale is simple. If you can borrow at lower rates, lend at lower rates.
The following table presents a comparison of the two methods: (Source RBI)
|Key aspects on calculation|
|Source of funding||Based on actual domestic funding mix||Banks can choose benchmark funding mix|
|Reference Rates||Marginal cost of deposits||Marginal/ Weighted Average/ Blended Cost|
|No of benchmarks||At least five: overnight, 1/3/6/12 months||One benchmark rate|
|Operating Costs||Allocable costs (higher than base rate)||Un-allocable costs|
|Return on equity||Included||Included|
|Review of rates||Monthly (quarterly review till March 2017)||Quarterly|
|Reset of loan rates||Can be set for individual loans, maximum 1 year||All floating rates loan re-price together|
|Fixed rate loans||Can be below MCLR rate||Can’t be below base rate|
Which loans will get linked to MCLR?
All floating rate loans will be linked to MCLR. Following loans are not linked to MCLR:
- Loans covered by government schemes where banks have to charge interest rates as per the scheme are exempted from being linked to MCLR as the benchmark for determining interest rate.
- Fixed rate loans
- Floating rate loan from a non-banking finance company (NBFC), where your loan will be linked to the retail prime lending rate and not MCLR.
- Does not apply to housing finance companies such as Housing Development Finance Corporation and LIC Housing
- All floating rate home loans based on BPLR, which was the lending rate used prior to base rate.
What does such a loan on MCLR will mean to you as a borrower?
If you take a floating rate loan now, then you know, it will be linked to MCLR. So you should be having two new things:
- A reset clause in the loan documents
Reset periods allow banks to partly smoothen the impact of changing rates on bank’s margins. The reset clause will depend on the bank and will vary. If you take a home loan from bank with reset clause of 1 year, the interest rate will get reset every year. For instance, if you take a Rs.10 lakh loan on 1 April this year, one-year MCLR is at 9.10% and spread on it is 25 bps, your home loan will be 9.35%. You will pay installments at this rate for the next one year. If on 1 April 2017, one-year MCLR gets revised to 9.15%, your home loan interest rate will get reset at 9.40% (MCLR of 9.15% plus spread of 25 bps). Accordingly, your installment or loan tenor may change.
An annual reset is a close equivalent of annual fixed rate and quarterly reset will fluctuate depending on policy decisions. So you need to carefully evaluate your loan contract based on your cash flows and risk appetite to pick the reset option.
- A spread
Spread is the margin that you have to pay over the MCLR. All MCLR-linked loans come with a spread. For instance, X Bank Ltd offers one-year MCLR at 9.10%. For a home loan, the spread is 25 bps, which means you get the loan at 9.35%. The spread may depend on your credit score or bank’s assessment of your repayment ability and hence negotiable. Further, the spread charged to a customer can be increased only in case of deterioration of credit risk profile of the borrower. Such decision must be supported by complete risk profile review of the borrower. Hence, increasing the spread may become operationally difficult for the banks.
How are you affected when you borrow new loans under MCLR regime?
If you borrow fresh loans under MCLR regime, you can expect reduction in your EMI much sooner if the RBI cuts repo rates and cost of borrowing in the system goes down. The only issue is that you will have to wait till the next interest reset date before you get the benefit of lower interest rate. In such cases, you may consider refinancing your loan from another lender.
Since the MCLR has to be published every month, banks cannot hide their borrowing cost from the customers.
But remember, MCLR is a double edged sword. Just as you expect interest rate cuts to be passed quickly, you must also expect interest rate hikes to be passed soon.
Will it change the EMI?
When the MCLR is reset, the tenure of the loan will be altered, keeping the EMI amount unchanged. However when the tenure crosses a certain number of years beyond which a bank has a policy of not lending, the EMI may change. But if you want to change the EMI and not the tenor, you can inform you bank.
Will the existing loans shift to MCLR automatically?
No. According to RBI, existing loans and credit limits linked to base rate will continue till repayment or renewal, and banks will have to continue publishing base rates as well.
Existing borrowers can move to MCLR-linked loans at mutually acceptable terms and these loans will not be treated as foreclosure of existing facility. You will have to inform bank of your intention to move the existing loan to MCLR.
How can an existing borrower move to MCLR?
Yes. An existing borrower can move to MCLR but remember shifting your loan to the new interest rate regime is a function of factoring the lower interest rate and the costs. There are some caveats:
- Besides the rate, you need to check the spread for your loans. In concept, MCLR is not very different from prime lending rate or base rate. The difference lies in the methodology of how to determine the rate. The method of linkage is the same. There is a spread over MCLR that banks charge. In case the difference is marginal, there is no point in switching.
- The borrower might have to pay a conversion fee or switching charges (usually 0.5% of outstanding principal) or some flat fee though negotiable.
- Additional paperwork
- Once a borrower of loan opts for MCLR, switching back to base rate system is not allowed.
When will Banks publish MCLR?
The MCLR will be reviewed on a monthly basis i.e. banks will disclose MCLR for various tenors every month. All the new loans during the new month will be offered at latest MCLR +Spread.
When and how will the interest rate be reset?
The interest rate reset period is at the discretion of banks. The only thing to note is that your loan interest rate may not get revised every month. It will be done at the next interest rate reset date as provided under the loan agreement between you and the bank.
For Example, your loan is linked to 1-year MCLR (say 9.2% p.a.) and the next reset date is March 1, 2017. Even if 1- MCLR is revised downwards to 8.9% p.a. in May, 2016, you will have to wait for at least till March 2017 before a lower MCLR can apply to your loan. Please remember 1-year MCLR announced for the month of March 2017 will apply to your loan at the next reset date.
RBI’s key guidelines on MCLR
- All loans sanctioned and credit limits renewed w.e.f April 1, 2016 will be priced based on the Marginal Cost of Funds based Lending Rate.
- MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to more efficiently price loans at different tenors based on different MCLRs, according to their funding composition and strategies.
- Banks have to review and publish their MCLR of different maturities every month on a pre-announced date.
- The final lending rates offered by the banks will be based on by adding the ‘spread’ to the MCLR rate.
- Banks may specify interest reset dates on their floating rate loans. They will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
- The periodicity of reset can be one year or lower.
- The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date (irrespective of changes in the benchmark rates during the interim period). For example, if the bank has given you a one-year reset period in your loan agreement, and your base rate at the beginning of the year is say 10%, even if the interest rate comes to 9% in the middle of the year, you will continue at 10% till the reset date. Same will be the case even if the interest rate increases above 10%.
- Existing borrowers with loans linked to Base Rate can continue with base rate system till repayment of loan (maturity). An option to switch to new MCLR system will also be provided to the existing borrowers.
- Once a borrower of loan opts for MCLR, switching back to base rate system is not allowed.
- Loans covered by government schemes, where banks have to charge interest rates as per the scheme are exempted from being linked to MCLR.
- Like base rate, banks are not allowed to lend below MCLR, except for few categories like loans against deposits, loans to bank’s own employees.
- Fixed Rate home loans, personal loans, auto loans etc., will not be linked to MCLR.