What is the MCLR Rate and How Does it Affect Loans?

Posted on Monday, April 22nd, 2024 | By IndusInd Bank

When you apply for a personal loan, one of the biggest factors that influences how much you’ll repay is the interest rate. But what decides this rate? That’s where the Marginal Cost of Funds based Lending Rate—better known as MCLR—comes into play. Understanding MCLR can help you make smarter loan decisions and manage your finances better. Let’s break it down.

What is the MCLR Rate?

MCLR stands for Marginal Cost of Funds based Lending Rate. It’s the minimum interest rate below which banks are not allowed to lend money, except in some special cases. Introduced by the Reserve Bank of India (RBI), MCLR serves as a benchmark for banks to set loan interest rates, including personal loans.

Why was the MCLR Rate Introduced?

Before MCLR, banks used a system called the base rate. However, it wasn’t as responsive to changes in the repo rate (the rate at which RBI lends to banks). This often resulted in delays in passing on the benefit of rate cuts to borrowers. Hence, MCLR was introduced in April 2016 to bring more transparency and efficiency in loan pricing and ensure quicker transmission of monetary policy.

What is the Base Rate?

The base rate is the previous benchmark used by banks to decide lending rates. It included the cost of funds, operating expenses, and a profit margin. But it lacked flexibility, which is why MCLR replaced it as a more dynamic and market-driven benchmark.

Also Read: Understanding Personal Loan Interest Rates

MCLR vs. Base Rate: Key Differences

• Flexibility: MCLR adjusts more frequently based on market conditions, while base rate changes were slower.
• Transparency: MCLR offers more clarity on how loan interest is calculated.
• Rate Transmission: MCLR is more closely linked to the RBI’s repo rate, making rate changes quicker and more borrower-friendly.

How is MCLR Calculated?

MCLR is determined using multiple components that reflect a bank’s actual cost of lending.

Components of MCLR

Marginal Cost of Funds

This includes the interest rate the bank pays on deposits and borrowings. The higher the cost, the higher the MCLR.

Operating Expenses

Banks factor in their operating expenses, which include administrative costs, salaries, and other overheads associated with lending operations.

Tenor Premium

The tenor premium reflects the additional cost banks incur for lending money over longer periods. A longer loan tenure typically means a higher risk, so banks charge an additional amount known as the tenor premium.

Cost of Borrowings

Banks often borrow from the RBI or other banks. These costs influence the MCLR.

Repo Rate Changes

The repo rate set by the RBI plays a major role. A change here leads to an update in the MCLR, which in turn affects your personal loan rate.

MCLR Calculation Formula

While each bank has its own detailed formula, in general:

MCLR = Marginal Cost of Funds + Operating Cost + Tenor Premium

Banks review and update the MCLR monthly to stay in sync with changing market rates.

Why Should Personal Loan Borrowers Care About MCLR?

As a personal loan borrower, knowing how MCLR works can help you:

• Understand why your interest rate changes over time
• Compare loan offers better
• Plan your repayments smartly

Frequent Checks, Thorough Reviews and Revisions

It is worth noting that the MCLR is checked and updated regularly by the Reserve Bank of India RBI.

Every so often, usually monthly or quarterly, the RBI looks at various factors such as the cost of borrowing money, the expenses banks have, and changes in the economy. Based on all these things, they decide if the MCLR needs to be changed or updated.

What Does MCLR Aim to Achieve?

Here are the five main aims of the Marginal Cost of Funds based Lending Rate in India:

• Transparency: MCLR aims to make the process of setting lending rates by banks more transparent and understandable for customers.
• Fairness: It ensures that lending rates are fair and based on current market conditions, reflecting changes in the economy and the cost of funds for banks.
• Responsive to Market Changes: MCLR’s goal is to make lending rates more responsive to changes in the economy, allowing for quicker adjustments to factors like the repo rate set by the Reserve Bank of India RBI and other market conditions.
• Efficiency: It aims to promote efficiency in the banking system by encouraging banks to manage their funds more effectively and pass on benefits to borrowers in a timely manner.
• Risk Management: MCLR was introduced to help banks manage risks associated with lending by ensuring that lending rates are sensitive to factors such as credit risk and liquidity risk.

Also Read:  5 Important Personal Loan Factors You Should Consider

To Conclude

Whether you’re taking a personal loan for medical expenses, home renovation, or debt consolidation, the MCLR directly affects your cost of borrowing. A basic understanding of how MCLR works helps you stay informed, ask the right questions, and make the most of falling interest rates when they happen.

So, the next time you’re comparing personal loan offers, don’t just look at the interest rate—ask about the MCLR too. It’s the key to unlocking smarter borrowing decisions.