The interest rate that you pay on your home loan plays a crucial role in determining the overall repayment amount. It might affect your monthly EMI by increasing or decreasing the cost of borrowing. For this reason, it is essential to exercise caution while selecting a home loan. As long as you take out a fixed-rate house loan, your interest payments will stay the same. A floating-rate loan, on the other hand, allows your interest payments to fluctuate with the variation in the benchmark rate. Banks use the MCLR as a basis for determining floating-rate loan interest rates.
It is thus possible to profit from a decrease in the MCLR rate within a short period of time. Let’s have a better understanding of what the MCLR stands for and how it impacts your EMI payments.
What is MCLR?
Marginal Cost of Funds based Lending Rate is the acronym for MCLR. It is a term used to describe the lowest possible annual percentage yield at which a banking institution would be willing to lend you money. The banks establish your interest rate based on this internal benchmark or reference rate. Formerly, banks relied on the base rate as the primary factor in determining interest rates. But in 2016, the Reserve Bank of India replaced it with MCLR.
What Makes MCLR Different From the Base Rate?
Before 2016, banks operated under a base rate system that determined the lowest possible interest rate at which they would lend you money. The bank’s interest rate calculations comprised the base rate in addition to a statutory spread of fifty basis points. Under the base rate system, borrowers did not reap the benefits of the predicted drop in wider market rates. Changes in the RBI’s interest rate were not effectively passed on to borrowers.
However, even if lenders were able to pass on rate reductions to borrowers, they had to wait for a long time to reap the benefits. The base rate mechanism was changed to the MCLR in 2016 to eliminate this issue. Most importantly, the reduction in interest rates is carried on to borrowers more quickly via MCLR-based loans.
This is all well and good, but you might be wondering how the change affects your home loan, right? Let’s find out.
How Does the MCLR Influence Your Home Loan?
If the MCLR rate changes, your monthly payment, as well as the length of your loan, will adjust accordingly. Your EMI or duration can go lower if the MCLR goes down. On the other hand, since MCLR-based house loans come with a reset period, it’s possible that you won’t see any immediate benefits from switching to one of these loans, provided the reset period is just around the corner. Home loans determined using the MCLR may provide clarity to the process of determining interest rates. Additionally, it makes the process of passing on the benefits of reduced interest rates to borrowers easier.
RBI Recommendations for MCLR
The Reserve Bank of India has established the following guidelines in relation to the MCLR system:
- MCLR adjustments should have no effect on fixed-rate mortgage loans.
- Financial institutions must disclose the MCLR rate for different repayment terms.
- When computing the MCLR rate, banks must consider both their deposit balances and borrowings.
- The floating home loan interest rate on the authorised date will stay the same up to the subsequent reset date, based on the relevant MCLR. In the repayment conditions agreement communicated with the borrower, reset dates are indicated.
How is it Calculated?
To begin, it is essential to remember that the following elements will determine the MCLR rate offered by each and every bank.
- Payback tenure premium – In order to cover the risk, banks shift the load to the borrowers by charging an amount in the form of a premium.
- Expenses that the bank must bear in order to run its operations
- Carryover deficit in the Cash Reserve Ratio (this is normally equivalent to four per cent of the funds that are deposited by clients of a bank into accounts that they have established with that bank.)
- Cost of funds on a marginal basis (the charges that were spent by the bank in order to get finance for the bank’s operations.)
After figuring out all of the above factors, you will be able to calculate the MCLR rate that is used by financial institutions. RBI recommends the following formula for this purpose:
Marginal cost of funds = (Marginal borrowing cost * 92%) + (return on the net worth * 8%)
Conclusion
For borrowers with fluctuating interest rates, MCLR offers some relief from the base rate. If you applied for a house loan after April 2016, there is a good chance that the interest rate on your loan is tied to the MCLR. On the other hand, the interest rate on house loans availed before April 2016 will be determined by the base rate. However, if you choose, you may change it to MCLR.
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