Since January 2015, the Reserve Bank of India has progressively reduced the repo rate by 150 basis points. As against this, commercial banks have reduced their base rates only by 50–60 basis points till March this year.
While cost of funds of banks have come down owing to lower policy rates, they could not match their lending rates with reduced policy rates as their average cost of borrowing still remained high because of older fixed deposits.
To make sure that the reduced policy rates are passed on to borrowers by banks, RBI introduced the Marginal Cost of Funds based Lending Rate (MCLR) methodology as an alternative to the earlier base rate system.
Why was it changed?
For the uninitiated, MCLR is calculated on the basis of four major components – marginal cost of funds, operating cost, tenor premium and negative carry on account of cash reserve ratio (CRR). However, simply put, MCLR is the cost of obtaining funds for banks that has now been closely linked to the repo rate. Any changes in deposit rate or repo rate impacts the lending rates of the bank and MCLR’s monthly reporting would mean banks would now be compelled to pass on benefits of rate cuts to borrowers.
It won’t be as simple for RBI to manage this as it may sound, given that they will have to keep a record of multitude of rates spread across different tenures (monthly, quarterly, half-yearly and annually).
The MCLR regime is applicable on floating rate home loans and term loans to SMEs and middle-level corporates. However, this will not apply to government-run credit schemes and fixed-rate home loans, personal loans, car loans or other fixed-rate loans.
While new borrowers are covered under the MCLR system from April 1, 2016, existing borrowers can continue with the base rate system till repayment of loans. The existing borrowers also have an option to shift their loans to the new MCLR-based system on mutually acceptable terms. However, once the borrowers decide to shift to the MCLR-based system, they cannot shift back to the old base rate system.
The lenders, on their part, will have to specify the interest reset dates while sanctioning loans. The MCLR of a loan will be applicable till its next interest reset date, irrespective of the changes in the MCLR rates by the bank during that period. To ensure transmission of policy rates, the RBI has capped the period between two reset dates at 1 year.
Similarly, like the old base rate system, banks are not allowed to lend below the MCLR.
For example, Axis Bank charges its floating rate home loans of up to Rs 28 lakhs @ 9.60 per cent per annum (9.45 per cent MCLR plus 0.15 per cent spread), whose rate of interest will be reset half-yearly. So, if you availed a home loan from Axis Bank on April 1, and the MCLR comes down to 9.20 per cent on July 1, you will still be paying interest rate @ 9.60 per cent till September 30 as your interest reset period is six months and it will not be reset before September 30. However, if the MCLR further gets reduced to 9 per cent p.a. on October 1, your rate of interest will also be reset at 9.15 per cent per annum (9 per cent MCLR plus 0.15 per cent spread) because of your half-yearly interest reset condition.
What should you do?
If you are an existing borrower, migrating to the MCLR system will make more sense as it is more dynamic, better regulated and more effective in transmitting the monetary policy than the old Base Rate system. Moreover, the current falling interest rate regime will ensure that the interest rate on your loan will keep reducing with reducing policy rates. However, if the RBI tightens its monetary policy in future, the MCLR will prompt the banks to swiftly increase their lending rates. Also remember that once you shift to the MCLR-based system, you cannot return to the old base rate system.
The author CEO & Co-founder, Paisabazaar.com