MCLR Rate: What it is and how to Calculate?

The Reserve Bank of India introduced MCLR or Marginal Cost of Funds based Lending Rate in 2016 to replace the existing base rate system that was in operation since 2010. This shift aimed to bring in more transparency in the process of interest rate determination and to help borrowers reap the benefits of RBI’s policy rate change early on. 

This new system introduced a minimum lending rate threshold in place under which financial institutions were not allowed to lend. Gaining an understanding of the working principles of MCLR rates can help borrowers repay their credit affordably and improve their financial management.

What is MCLR?

The MCLR rates are the minimum rate of interest at which financial institutions can offer loans and advances to retail customers. Lenders use it as an internal benchmark to determine the rate of interest on every credit option. Under this regime, financial institutions are mandated to keep the minimum rates unto the threshold of a pre-determined lending rate on various loan products.

Therefore, lenders cannot favour any customer and offer a lower interest rate on a specific maturity. They need to stick to the MCLR rate, which remains uniform for all credit options linked to that benchmark. The reason to introduce MCLR is that the lending system counts in the RBI’s policy rate changes, making it easier to pass on the benefits of policy rate cuts to the customer.

With this understanding of what is MCLR rate, take a look at its calculation as well.

How is MCLR calculated?

Since the MCLR rate is a tenure-linked interest rate, it means financial institutions can determine the rate of interest as per the repayment tenure of a loan. The calculation of MCLR is based on four factors plus a percentage spread that a financial institution adds to the benchmark rate. These are –

  1. Tenure premium

It is an amount that lenders charge to cover the risk associated with a loan as per the tenure availed. However, tenure premium is not specific to a particular credit option. Instead, it is uniform across all loan types and varies only with the tenure differences.

  1. Marginal Cost of Funds

Marginal Cost of Funds takes into account the existing borrowings of a financial institution for MCLR calculation. It includes credit availed from the RBI at a set repo rate. For instance, the current repo rate considered for such calculation would be 4%. It is primarily made up of two components, namely Return on Net Worth and Marginal Cost of Borrowings. Here, the weightage on the Marginal Cost of Borrowings is 8% and on Return on Net Worth is 92%.

  1. Negative carry on the Cash Reserve Ratio

Cash Reserve Ratio or CRR represents the fund that a financial institution operating in India has to mandatorily keep with the RBI towards ensuring security and liquidity. Any loan extended is calculated negatively against the reserve in the books of a financial institution as they cannot generate any income from it.

  1. Operating cost

A lender incurs a series of varying costs to ensure smooth running of its operations. It includes the salary of the employees, interest on deposits, rent of branches, etc. Calculation of MCLR rates considers these costs to arrive at the final rate of interest to be charged on a particular financial product.

Benefits of MCLR rates over the base rate system

The prominent benefits of MCLR and its effects on loans have been demystified below –

       It brought the much-needed transparency in the calculation of interest. In the base rate regime, such transparency was an important issue shrouding the interest levy.

       Under MCLR, marginal cost of funds was considered instead of the total cost of funds. As a result, it considers the repo rate in its calculation that base rate never did. This results in better benefits to the borrowers.

       Furthermore, financial institutions revised this rate periodically, which helped borrowers to avail better interest rate.

Nevertheless, with an introduction of RLLR or Repo Linked Lending Rate as an external benchmarking system of lending replacing its predecessor MCLR rates, the rates of interest on advances are set to gain further transparency. This lending system has also been mandated in case borrowers avail a home loan at a floating rate, thus ensuring increased affordability for housing loan borrowers.

While applying for a home loan, borrowers should thus check if their preferred lender is offering this facility or not.

Renowned lenders also provide pre-approved offers to make loan processing hassle-free and time-saving. These offers are available on several financial products, like home loans, loans against property, etc. Borrowers can check their pre-approved offers by submitting their essential details only.

Therefore, before applying for a home loan, borrowers should consider the best lending system to ensure easy repayment of their advances. Along with that, they must also take care of the important reasons why lenders may reject a home loan application and rectify them to improve their chances of approval.

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