Decoding MCLR: Should you switch to MCLR from Base Rate?

Marginal Cost of Fund-based Lending Rate (MCLR) is the interest rate introduced by RBI in April 2016 to overcome the disadvantages of the base rate system. MCLR is more in sync with the interest rates set by the RBI.

A significant advantage of MCLR is that it is in line with the current interest rates of the RBI. This allows the customers to be directly benefitted by rate cuts, which were previously reluctantly or never passed on to the borrowers by the commercial banks. Since MCLR is hugely dependent on the marginal cost of funds (rate of borrowing from RBI), any change in the repo rate brings a change in this rate, which is passed on to the customers immediately.RBI has directed banks to calculate at least 5 MCLRs including:

• Overnight
• 3 months
• 6 months
• 1 Year

Four components are used to calculate MCLR:

• The marginal cost of funds Calculated by considering 92% of the cost of incremental borrowing from RBI and 8% of the return on net worth.
• Negative Carry on Cash Reserve Ratio (CRR): Mandatory deposits of the banks with the RBI (CRR) do not provide any return and are referred to as negative carry on CRR.Negative Carry = CRR*Marginal Cost/ (1-CRR)
• Operating Cost Operating Costs are all indirect expenses incurred to raise funds, including staff salaries, rent, etc.
• Tenure Premium Tenure is the period of reset of interest rate, which directly impacts the premium. Higher tenure results in a higher premium. Such as if the loan tenure is 7 years, but the rate reset is done annually, then MCLR calculated for the year will be applicable.

Additionally, the banks will also charge a spread depending on the credit score or repaying ability of the borrower.

Borrowers have two options:

• Switch to MCLR in the same bank or transfer the loan to another bank
• Continue the base rate, if tenure is ending soon

Generally, switching from base rate to MCLR will benefit because it will lower the interest paid and result in significant savings, even after considering the switching charge levied by banks.However, some disadvantages include:

• MCLR spread controlled by banks
• MCLR is reviewed on fixed dates irrespective of repo rate changes
• Applicable only for loans borrowed at floating interest rates

Overall, MCLR is expected to benefit the borrower. However, one must analyze all aspects before making the final switch.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.