MCLR-based Home Loans: Everything You Need to Know

‘RBI slashes REPO rates by 50 basis points!’ A newspaper headline like this would mean only one thing to Home Loan borrowers: interest rate cuts. Banks, however, have been reluctant to transfer the benefit of REPO rate cuts to final borrowers. But that is a story of the past. With the introduction of MCLR, borrowers can gain from rate cuts in real time. Here is all you need to know about MCLR-based home loans:

1. What is the meaning of MCLR?

The RBI issued a new set of guidelines known as the Marginal Cost of Funds-based Lending Rate (MCLR) Commercial banks must use the MCLR to set their interest rates. This system replaced the base rate system with effect from 1 April 2016. Its main purpose is ensuring that banks pass on the benefit of rate cuts to borrowers. It’s quite a departure from the Base Rate regime.

2. What was wrong with the base rate?

The RBI introduced the base rate system in the year 2010. This was a replacement to the Prime Lending Rate (PLR) system. The base rate is the minimum rate of interest that is fixed by all banks. The base rate sought to ensure that banks do not lend to customers below a certain benchmark. The RBI also wanted to make sure that any changes in interest rate policy were handed down to borrowers. But the transmission of interest rates was not effective in the base rate system. Even if the RBI cut the REPO rate, banks did not always follow suit. They did not pass on the full benefit to the customer. Or, there was a big-time delay, which defeated the goal of the rate cut. To improve the process, the MCLR rate system came into play in April 2016.

3. How does MCLR work?

Under the base rate system, the pricing of loans depended on a spread over the base rate. For instance, suppose the base rate was 9.2% per annum and the spread was 50 bps. Then the interest rate on the loan was 9.7% per annum.

Imagine that you took a home loan on 1 February 2017. You got this at a one-year MCLR of 9.1%. Now, suppose the spread is 25 basis points. Then the interest rate will be 9.35% (9.10%+0.25%) per annum. This interest rate will be valid until 31 Jan 2018. After that, the rate will reset automatically. Going forward too, banks will be reviewing the MCLR every month. This means, you can expect the rate to change regularly under MCLR-based home loans, unlike the base rate.

Such revisions, therefore, ensure that lenders pass on rate cuts to consumers, unlike the earlier base rate system.

4. Calculating the rates

The major components that are used to calculate the rates are:

The base rate system does not incorporate the repo rate in its calculations. So, any change in REPO rate does not reflect directly in the interest rates proposed by banks. On the other hand, the MCLR rate depends on the marginal cost of funds to a large extent. The REPO rate is a big factor in the calculation of the marginal cost of funds. So, any change in the REPO rate brings a major change in the marginal cost of funds. This forces banks to change the MCLR right away. Example: If you have a 20-year home loan of Rs 40 lakhs at 9.95% under base rate. 3 years of the loan tenor are over and you have paid an EMI of Rs 38,468 and an interest of Rs 11,63,514 in the time frame. Approximate outstanding loan at the end of 3 years will be Rs 37,78,650. If you continue with it, your overall interest outgo would be a whopping Rs 52,32,428. Now, if you switch the outstanding loan to MCLR with your current lender at say 8.55% after 3 years, what will be the implications for the next 17 years? Here is a table explaining it.

    The cost comes out to be Rs 45,63,910 (34,00,396 + 11,63,514) while switching the loan. You save around Rs 6,68,518 (52,32,428 - 45,63,910) by switching to MCLR option.

Additional read: Your guide to getting a better home loan interest rate

5. Should you switch?

All loans sanctioned from 1 April, 2016 follow the MCLR system. Borrowers who took loans before this date can switch their loans from the base rate to MCLR. But is switching a good option?
That depends on the cost of the loan. Borrowers under the MCLR system benefit from a cut in the REPO rate. But the interest rates can increase if the RBI increases the REPO rate.
Generally, the cost of conversion is anywhere between 0.5–0.6% of your loan amount. Does your loan turn out to be cheaper in the MCLR regime after you pay for the conversion? Then it makes sense to go ahead.
But lenders are slashing the MCLR across all tenures by 90 basis points. So, it might be a good choice to switch now.

In summation

he base rate system is not completely outdated. But, MCLR rate can be a better system in terms of interest rate calculation. This can ensure consumers benefit every time there is a change in the REPO rate.

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