In July 2010, RBI introduced a base rate lending system for Banks. The system ensured that banks could not lend below a certain benchmark rate. This also ensured that whenever the RBI announced a change in repo rate, the banks could pass on the benefits to its home loan customers.
The repo rate is the rate at which RBI lends money to the banks. If the rate at which this lending happens is brought down by the RBI by, say 0.5%, then the banks have room to bring down the lending rates to the same extent.
However, banks were not as prompt in passing on the benefit to the customers. The banks calculate the base rate based on its cost of funds, the expenses towards efficient operations of the bank, minimum rate of return and cost of maintaining a cash reserve ratio (CRR). The CRR must be parked with the RBI by the banks as a regulatory requirement and the banks do not earn any interest on the CRR.
As per the new RBI guidelines effective from 1st April 2016, the banks should lend based on Marginal Cost of Lending Rates (MCLR). The MCLR factors the repo rate in addition to the other traditional factors. Hence, whenever the RBI changes its rates during a policy review, it does influence the MCLR.
How is final lending rate calculated?
The final lending rate of the bank, now, would be the sum of the bank’s MCLR plus the spread. The banks would review and publish their MCLR every month on a specified date. A person with a home loan could check the existing MCLR and opt for a switch to the MCLR method.
How does MCLR work?
Let’s say you have taken an MCLR based home loan of 40 Lakhs in July 2016 and the MCLR set by the bank is 9% and the spread is 0.3%. Your bank will charge an interest rate of 9.3% for the next one year. Even if the MCLR is reviewed and changed every month, your interest rate will remain 9.3% in the coming year. In July 2017, when the MCLR reset happens, let’s assume that the MCLR set by the bank is 8.5%. Then your home loan interest rate would be 8.8% (8.5+0.3).
To Switch to MCLR or not?
Imagine a situation wherein your base rate based rate of interest on home loan is 10%. If the MCLR calculated by the bank is 9% and the spread is 0.3%, your total interest rate would drop from 10% to 9.3%. Now, you would have to pay charges to the extent of 0.5% + taxes of the outstanding principal amount of the loan to switch from base rate to MCLR based loan.
Compute the amount paid towards switching to MCLR and then check the saving you make on interest in the year. Will you make a reasonable saving by switching over to MCLR? If yes, then it is a good option.
Generally, if interest rates are falling and the economy is becoming increasingly robust, it is good to switch to MCLR based lending. However, you must check with your bank if they allow a reset with the MCLR every six months, or once a year and then take a decision.
It is important to note here that once the MCLR is set, it will be reset only at the next reset date which could be a year away. This means that even if the MCLR reduces by 0.5% or 1%, the rate of interest for you would change only on the next reset date. The same is true if the MCLR increases by 1%.
I would recommend you to consider all these factors and calculate the amount of money you would save on interest, not only in the next financial year but throughout the tenor of your loan. It would give you a clear indicator and enable you to make a well-informed decision.