The MCLR serves as a benchmark rate or reference rate inside the financial organisation. The methodology for determining the bare minimum interest rate on a mortgage loan is defined by reference to the marginal cost of funds. In 2016, the Reserve Bank of India implemented the MCLR methodology into the Indian monetary system. After the base rate system was implemented in 2010, the MCLR system was implemented.
See also: What is repo rate and how it impacts borrowers?
What is MCLR?
Credit limit adjustments and new loan approvals are made by the MCLR guidelines. The minimum rate of interest a financial institution is legally allowed to charge is known as the marginal cost of funds-based lending rate (MCLR). Lending rates offered by most financial institutions are capped by their marginal cost of funds. With the approval of the Reserve Bank of India, however, some exemptions are possible (RBI).
India’s central bank, the Reserve Bank of India (RBI), establishes a mandatory benchmark rate for financial institutions. This rate is then used by RBI-regulated financial institutions to establish a floor for interest rates on various types of loans. When there is a significant shift in the country’s economy, RBI will adjust this rate. A bank is not permitted to make loans at a rate lower than the marginal cost of funds rate (MCLR).
Link between MCLR and bank’s interest rates
After implementing MCLR, interest rates are set based on each client’s particular risk profile. In the past, banks were slow to lower their interest rates for borrowers once the Reserve Bank of India (RBI) lowered the repo rate. Banks operating under the MCLR regime are obligated to update their interest rates in response to fluctuations in the repo rate. With this change, we want to encourage more transparency in the method banks use to determine the cost of loans. It also guarantees that customers and banks will be able to access credit at fair interest rates.
A loan’s interest rate is not constant during its lifespan. The risk involved increases as the loan’s term length increases. The bank will charge a premium to the borrowers to offset the cost of the risk. The Tenure Premium is the name given to this payment.
Base rate and MCLR
Banks establish the MCLR based on a predetermined framework and method. In conclusion, this is good news for debtors. We can think of MCLR as a more refined form of the traditional base rate. A borrower’s final interest rate is established using a risk-based pricing model. The marginal cost of funds, rather than the total cost of funds, is one of the unique factors taken into account.
The repo rate, which is not included in the base rate, is factored into the marginal cost. Banks are required to factor in all interest rates they incur when mobilising funds into the MCLR calculation. Whether or not you should move to MCLR from the base rate is heavily influenced by the advantages you get and the expense of making the transition. It costs varying amounts to make this change at different banks. However, some financial institutions provide a fee-free option to switch mortgages to MCLR.
MCLR rate: Formula
A bank’s marginal cost of the funds-based lending rate depends on its total borrowing cost, which can only be determined by looking at its whole borrowing capacity. A bank may get funds from various accounts, such as savings, checking, and fixed deposit accounts.
You can determine your marginal borrowing cost based on the interest rate offered by these lenders. A bank’s finances come from a combination of equity and borrowing, both of which you must take into account (retained or infused earnings). Thus, one might anticipate a return on equity.
Below is the Reserve Bank of India-mandated methodology for determining MCLR:
To calculate the marginal cost of funds, take the average rate at which deposits of a certain maturity were raised for a given period preceding the review date. The bank’s records will reflect this fee by increasing the amount of money owed.
The marginal cost of funds = Marginal borrowing cost x 92% + return on the net worth x 8%
The return on net worth and the cost of borrowing money are only two components of what is known as the marginal cost of funds. The return on net worth only accounts for 8% of the total, while the marginal cost of borrowing makes up 92%. That eight percent corresponds to the risk of weighted assets represented by a bank’s Tier I capital.
Fundraising expenditures are considered part of operational costs unless they are specifically recouped via service charges. Therefore, it is related to the actual process of extending the loan. When the return on the CRR balance is zero, the CRR is said to have a negative carry. When the return on investment is lower than the cost of the funds, we say that the carry is negative.
This will affect the required reserve that all commercial banks must have in place according to the Statutory Liquidity Ratio (SLR). Since the bank can’t make any money off of the transaction, it has to record the transaction as a loss.
FAQs
What exactly do you mean when you say MCLR rate?
Loan interest rates at financial institutions are capped at the MCLR (Marginal Cost of Funds Based Lending Rate). Under the MCLR system, banks may provide any kind of loan at either a fixed or variable interest rate. The current MCLR (overnight) fixed by the RBI stands in the range of 6.80% to 7.65%.
What are the components of MCLR?
MCLR is calculated internally by the bank based on four components – Marginal Cost of Funds, Cash Reserve Ratio (CRR), Tenure Premium, and Operating Costs.
When comparing MCLR with the base rate, which is preferable and why?
According to research by the Reserve Bank of India (RBI), rate rises are better communicated under the Marginal Cost of Funds-based Lending Rate (MCLR) regime than in the base rate regime. The cost of financing for banks is determined according to a predetermined formula under the MCLR system.
