The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend. It is an internal tenor linked benchmark or reference rate for the banks. The MCLR methodology was introduced by the RBI w.e.f. 1st April 2016 which replaced the erstwhile base rate system.
The MCLR methodology was introduced to ensure that the changes in the Repo rate (lending rate charged by RBI from banks for short term funding) as announced by the central bank from time to time are incorporated in the lending rates of the banks. It is now mandatory for banks to consider the changes in the repo rate before calculating their MCLR. If the repo rate falls, lending rates of banks would also come down and vice versa.
Banks will review and publish their MCLR of different maturities, every month, on a pre-announced date. Banks have to publish at least five MCLR rates (overnight, 1 month, 3 months, 6 months and 1 year) The banks can choose to have more (for longer tenors like 2 years or 3 years also).
Components of MCLR
Marginal cost of funds- This is the cost of current borrowings to the bank. It comprises of marginal cost of funds and return on net worth with appropriated weights. In the case of MCLR based loans, the last month deposit rates (current, savings, term deposits etc) will be considered to arrive the cost of funds. Banks not only consider the current borrowing cost but also their profit margin which is also included in this Marginal Cost of Funds. This is called the Return on Net worth. The return on net worth is nothing but the bank’s profit they want to earn from their lending business.
Negative carry on account of cash reserve ratio (CRR)- It is the cost of keeping idle cash reserves with the RBI as a mandatory statutory measure. CRR is the blocked money banks have to maintain with the RBI, who in turn does not pay any interest on CRR held by the banks. Thus the return on CRR is Nil which is required to be recovered from loans advanced by banks.
Operating costs- The costs associated with providing the loan products including cost of raising funds. Such cost may include the salaries, rent or other overhead expenses
Tenor premium- If the bank is lending for higher tenors (like home loans), then there are uncertainties associated which are not factored in the MCLR calculated based on (say) 1-year MCLR. Therefore, the banks will charge a premium to the borrower for the risk (uncertainty) associated with lending for higher tenor loans.
The actual lending rates of the banks are determined by adding the component of credit risk spread (the rate of interest which is over and above the MCLR) to the MCLR. This spread depends on many things including the risk profile of the customer and the tenure of the loan. Usually, this spread will remain constant for you throughout the loan tenure.
How does MCLR?
Now let us assume that you applied for a home loan of Rs. 30 lacs with a 20 years tenure in the month of May 2017. The 1 year MCLR rate of the bank is 8.10%. Adding the credit risk spread say of 0.35% the bank will lend at 8.45%. (MCLR + Spread). Since the bank chose to apply the 1 year MCLR rate, the inbuilt reset clause in the loan agreement will allow the bank to change the interest rate only after 1 year i.e. May 2018. Similarly if the bank had applied the 6 months MCLR, the reset would automatically apply after every 6 months depending on the deposit rates at that time.