MCLR refers to the marginal cost of funding based on lending rates. Simply put, by the MCLR method, banks decide its minimum rate of interest for Home Loans. Hence, they serve as an internal benchmark or as reference rates for banks to decide interest rates for home loans.
As there are tons of home loan tax benefits available to a borrower, it becomes essential to know more about the functions of MCLR.
What is MCLR?
MCLR or Marginal Cost of Funds based Lending Rates is the minimum interest rates beyond which a bank cannot provide a loan. In other words, MCLR is the process by which the minimum interest rate is decided by taking into consideration the marginal cost or additional cost incurred by the bank to provide one extra rupee to its borrowers.
The methodology of MCLR was introduced in April 2017 by the Reserve Bank of India to replace the existing system of base rate that was introduced in July 2018.
These were done to bring more transparency in the banking system and make transmission easier from policy rates to bank rates. Other advantages like lower interest rates made available to borrowers and greater competition between banks leading to better services are also there.
How does MCLR make Home loan cheaper?
To answer the above question, first, you need to understand the base rate system. The base rate is the minimum rate of interest of a bank below which a bank cannot give loans.
The base rate was fixed based on factors such as profit, bank rates and bank cost bank. Therefore, it varies from bank to bank and was generally reviewed quarterly. Before base rate, the bank decided its rate of interest according to PLR (Prime Lending Rates).
During PLR system, the bank had the discretion to offer loans below the minimum rate of interest, depending on the customer’s credibility and the loan amount was low.
Therefore, the base rate was introduced to bring transparency to the system and benefit the consumers.
However, base rate proved to be inadequate because it failed to transfer the benefits of lower repo rate to the consumers.
What is repo rate? Repo rate is the rate at which the RBI lends money to the commercial banks. It is a vital tool for controlling inflation as higher repo rates discourage banks from giving out loans to borrower’s thereby decreasing money supply in the economy.
Due to this reason, the system of MCLR was introduced which is influenced by factors such as:
- Repo rate
- CRR or Cash Reserve Ratio- It is the minimum amount of deposit kept by a bank with the RBI which has no interest rates. However, under MCLR, CRR has negative carry meaning it has some allowance of earning interest.
- Operating cost of the bank- This refers to raising of funds, the opening of branches and giving salaries to employees which were not taken into consideration during base rate system.
- The marginal cost of funding- This basically refers to the marginal cost of borrowing such as fixed deposits, current account, savings account, etc and return on equities.
- Tenor-It means the time left for repayment of a loan which is linked to reset period of MCLR. The MCLR is liable to be reset at least once a year if not done in 6 months. A reset period varies from bank to bank. This can result in a decrease of interest rates which affects the loan tenure. Therefore, low Home Loan interest rates will automatically mean lower tenor.
Now coming to home loans, suppose you have taken home loan amounting to Rs.40 lakhs, prior to April 2017. According to base rate system, your EMI comes to around Rs.38,000 (approx.) to be given for a period of 20 years where the home loan interest rate is taken as 9.95 percent.
Imagine that three years have already passed since you have taken the home loan and you have already paid a portion of the principal amount. Your outstanding amount comes to around Rs.52 lakhs (approx.) if you continue to follow base rate system which is to be paid for the next 17 years.
Your bank gives you the option to switch from base rate to MCLR. Taking MCLR at 8.55 percent, your EMI comes to around Rs.34,000 (approx). Now calculate the total interest amount which comes around Rs.45 lakh (approx). Therefore, you will be saving an amount of Rs.6,000 (approx).
It is important to note that banks will charge an amount for switching from one system to another. Moreover, MCLR is only effective for home loans with floating interest rates. If you have taken a fixed rate home loan, then the option of switching is not available for you.
If you are looking for other loan offers and financial services, Bajaj Finance has pre-approved loan offers on personal loans, home loans, business loans and other financial product customized to your individual needs. These pre-approved loan offers not only simplify your financial decision making but it is also time effective.