Marginal Cost of Funds Based Lending Rate (MCLR)

Have you ever wondered how interest rates are set for Personal Loans, Business Loans, Home Loans, etc.? Of course, you already know that this rate is based on the loan amount, repayment tenure, and other factors. But another lesser-known factor also plays a role in interest rates. It is called the Marginal Cost of funds-based Lending Rate (MCLR).Understanding MCLR is crucial to making informed decisions when securing funds for personal or business financial needs. An internal interest rate-setting mechanism in banks benefits you, as a borrower, over the base rate. Under the MCLR system, you benefit from reduced repo rates when taking a loan.

EBLR refers to the External Benchmarks Lending Rate. RBI dictates that floating interest rates for all loans to micro and small businesses and retail loans be pegged to EBLR. Banks and financial institutions cannot offer loans below the EBLR to individuals and small businesses.EBLR is one of the measures taken by RBI to ensure transparency in the lending market.Various loans such as Personal Loan, Home Loans, and Unsecured Business Loans are disbursed at interest rates calculated based on EBLR. The applicable interest rate on such loans will include EBLR plus a risk premium calculated based on collateral asset value, credit history, financial health, and tenure.

• MCLR is an internal benchmark or reference rate that each bank determines after considering various factors, such as operating costs, cost of funds, profit margins, etc.
• MCLR is the minimum lending rate banks use to set the interest rates on different loans. Usually, the lending rates are above this minimum rate.
• Banks cannot offer their customers loan interest rates below MCLR, except in some cases permitted by the Reserve Bank of India (RBI).
• To determine their lending rates under the MCLR system, banks consider the marginal cost of funds (the cost of arranging one more rupee to the borrower) instead of the average cost.
• MCLR applies to all loans, whether a Personal Loan , Housing Loan, Business Loan or other types of loan.

Banks usually review and revise the MCLR every month. The effective date to review and revise the rate differs for different banks.Also read: Effects of MCLR on the economy

MCLR ensures that banks adjust their interest rates on loans to reflect changes in the cost of funds. Its calculation is based on the following factors:

Marginal cost of funds or borrowing

The marginal cost is the incremental cost to provide an additional unit of goods or services. In the case of banks, it is the expense incurred to provide an additional rupee to the borrower, like the interest rate it pays.

Tenure premium

MCLR is a tenure-linked internal benchmark. Banks keep in mind the tenure of a loan to offer interest rates. For instance, long tenures increase the risk involved. To determine the MCLR, the bank considers this premium to cover the risk.

Negative carry-on account of CRR

All banks maintain CRR (Cash Reserve Ratio) with the RBI. It is a certain percentage of the total deposits in the bank's reserves. They do not earn any interest on this amount, as it cannot be extended as a loan.
From the bank's perspective, it has to pay an additional cost to provide loans. Since the bank does not earn anything on these funds, the cost of these funds gives a negative figure.

Operating costs

Banks cover the operating costs incurred to extend the loan under the MCLR. It includes the cost of funds, stamp duty, legal expenses, printing costs, etc. When a bank works more efficiently, it can offer loans at comparatively lower rates.

The cost of funds is based on the RBI's current repo rate and reverse repo rate. The former refers to the interest rate at which the central bank – the RBI – lends funds to Indian banks, and the latter is the rate at which it borrows funds from the banks.Whenever the RBI reduces its policy rates, it expects banks in the country to reduce their interest rates for borrowers. This aim, however, was not met with the previous base rate system.Before the introduction of MCLR, different banks followed different methods to calculate the minimum lending rates. For example, some considered the average cost of funds, while others considered the blended cost.The MCLR system was introduced with the following aims:

• For effective transmission of the RBI's policy rates into the banks' lending rates
• To make the banks' interest rate-determining system transparent
• To ensure fair interest rates for all borrowers
• To provide a competitive sphere to banks, helping them enhance their long-run value and contribution to economic growth.

Also read: Effects of MCLR on loans

The base rate is an interest rate set by the Reserve Bank of India, below which banks and other financial institutions cannot lend. It serves as a minimum interest rate applicable on loans. RBI developed the base rate to ensure borrowers know the minimum interest rate, bringing about transparency in the lending system. The applicable interest rate on a loan will be the base rate plus a risk premium.For example, if the base rate is 6% and the risk premium on your Personal Loan is 5%, then the applicable interest rate will be 11%.

The MCLR system is a dynamic lending rate system that ultimately boosts the efficiency of the bank's interest rate setting, a mechanism that benefits borrowers. Here's how:

• The MCLR system improves the transmission of monetary policy changes to borrowers. MCLR ensures that you benefit from the lower cost of funds with every decrease in the RBI's policy rates.
• With increased transparency under the MCLR system, you can understand whether the offered loan interest rates are fair.
• Under MCLR, all banks must disclose their interest rates for one-month, overnight, three-month, six-month, one-year maturities, etc.; borrowers can find this information on the bank’s website.

Also read: Should you switch to MCLR from base rate?

• MCLR is a method banks use to determine the minimum interest rate for loans based on the additional/incremental/marginal cost of borrowing to benefit their customers.
• Unlike the previous base-rate system, MCLR brings transparency and fair lending rates for all borrowers and lenders.
• You can make informed decisions with an insight into the methodology banks use to determine your loan interest rate. Visit https://www.adityabirlacapital.com/ for more information.