Generally, there is a lack of transparency in the way banks used to decide their benchmark rate to lend to borrowers. Banks would generally offer fixed rate loans and even if RBI would cut the interest rates, banks would not cut their lending rates or cut it very slowly. Looking into such inefficiency, on 1st of April 2016, RBI first implemented the MCLR based lending rate to determine the interest of different loans.
MCLR or Marginal Cost-based Lending Rate which is an indicator of bank’s cost of funds and it should move with changes in RBI’s repo rate. All the banks are required to reset their MCLR on their website by 7th of each month.
This was a much-needed change in the banking system for the benefit of the customers, especially for the SMEs and MSMEs and also for the individual customers. Earlier when RBI used to cut interest rates, the benefit of the same used to pass on to the customers after a long time. With the introduction of Under MCLR regime, the financial institutes have to alter and adjust the floating rate loan lending rate accordingly as soon as there is any change in the repo rate.
Generally, commercial banks do not lend below MCLR. However, there could be few instances where banks could lend below MCLR rates. Such instances are very few and restricted to high rated corporates who may need a very customized loan.
Objectives Of MCLR:
- The primary objective of MCLR is to provide the benefits of a rate cut to the end customer as soon as the cut happens.
- To bring transparency in the determination of lending rates by commercial banks and other financial institutions
- To make it all fair for the lender and the customer it ensures the availability of loan interest at reasonable rate.
- To improve the worth of the lending institution and for bringing in healthy competition.
How is MCLR Calculated?
The calculation of MCLR is based on the repayment tenor of the loan. The lending institution takes into account the different element (mentioned below) spread and adds it to this tenor-linked reference rate, which is decided internally. Moreover, after a thorough review, the lending institute publishes the MCLR for different maturities of loans (time period like Overnight, 1 month, 3 months, 6 months, 12 months monthly, quarterly, etc.).
The primary four elements/factors which are taken into consideration for calculating MCLR are –
Tenor premium:
The loan tenor premium is for all the loans irrespective of the class of the loan or who is borrowing. It is because of the uniformity found in the tenor period. It is the same for all types of loans for the remaining tenor, which is specified.
The marginal cost of funds:
It comprises of Marginal cost of borrowings and return on net worth, appropriately weighed. While computing marginal cost of funds, 92% weight is assigned to the marginal cost of borrowing and 8% return on Net worth. Here, marginal cost of borrowing is referred to average rate, which was used to raise funds/deposit having a similar tenor in the period preceding the date of MCLR review, weighed by their outstanding balance in the bank’s books
Operating Cost:
The operating cost is mostly the cost of raising funds and giving loans but excluding the cost which the lending institute recovers via service charges.
It arises because banks have to maintain a certain percentage of their deposits with RBI (presently 4%) and on those deposits’ banks do not earn any interest. While banks continue to pay interest to its depositors. This results in negative carry for banks. Such % of non-earning deposit is called Cash Reserve Ratio (CRR). Similarly, banks may earn lower return on Statutory Liquidity Ratio Balance (SLR) deposits as compared to their cost of funds and this results in additional negative carry.
Generally, by the 7th of each month, Commercial banks publish MCLR for different maturities of loans (time period like Overnight, 1 month, 3 months, 6 months, 12 months monthly, quarterly, etc.)
What is the relation between MCLR and final interest rate charged to the borrower?
As mentioned above, rate of interest charged by banks is generally higher than MCLR. The final rate of interest charged by banks to the borrower is calculated as follows:
Final interest rate = MCLR + credit spread
The main trick is to understand “credit spread”. Credit spread is the additional interest that bank would charge to cover the credit risk of the borrower. The spread would be lower for a highly rated borrower and higher for lower rated borrower. Please note that the spread could be negotiated and could vary from bank to bank. The spread is fixed at the time of disbursal of the loan and only changed if there is a significant alteration in the borrower’s profile. Borrowers with high credit rating and good track record could negotiate for a small spread. For average borrowers, the spread could be about 1%.
For example, a bank quotes spread of 0.3% or 30 basis points on 12-month MCLR benchmark. For that bank, assuming, MCLR for a one-year is 8.2%, then final interest rate for borrower would be 8.2% + 0.3%= 8.5%.
How to choose between two banks while taking loan and how to choose correct MCLR
First off, we strongly suggest not to borrow from banks who offer fixed rate loans and do not link it to MCLR. Some banks in market, would verbally assure to the borrower that they would reduce the interest rate as per market. However, they would not give this assurance in writing and not mention it in sanction letter. Such banks lack transparency. We strongly suggest to avoid such banks or insist to take a written clarity on how they would change their lending rate with changes in interest rate environment.
Another important aspect is to study the pattern of increase and decrease in MCLR – Study historical data of that bank on changes in MCLR. It is better to choose a bank which has also reduced its MCLR by a % very close % of interest rate cut by RBI. There are banks which increases rate faster and by a large % during the period in which RBI is increasing interest rate but do not reduce MCLR faster during the periods in which RBI is reducing interest rates. You may use a tool developed by Edugains to compare MCLR trends of various bank – https://edugains.in/mclr/
Choose a bank which is offering lower credit spread – For example, what would you do if there are two banks XYZ and ABC offering loan at 9%p.a.
1) Bank XYZ MCLR of 8.5% and Spread of 0.5%
2) Bank ABC MCLR of 8.25% and Spread of 0.75%
We will suggest to go for option 1 as floating interest rate (MCLR) changes but Spread doesn’t change often. Also, India now is on interest rate cutting cycle so with time MCLR of banks would reduce
Choose correct MCLR – During the period of reducing interest rate by RBI (which is presently being done), choose a short term MCLR like 1 month or 3 months so that every one month or 3rd month your interest rate would be reduced. During such periods, banks may want to link interest rates to 12-month MCLR so that they don’t have to reduce the interest rate often. During periods of RBI increasing interest rate, chose 12-month MCLR. If it is not clear whether RBI is in interest rate reducing or increasing phase, choose a safe bet of 6-month MCLR.
Edugains with its banking experts can help vet your credit sanction letter with respect to interest rate clauses and identify ways to reduce overall interest rate. Its experts are dealing with many companies and many banks and this rick experience can help you choose the right bank for you.