In 2016, the Marginal Cost of Funds based Lending Rate (MCLR) was launched to replace the base rate structure and pass down the benefits of rate cuts to retail borrowers. Though both MCLR and base rates serve as internal benchmarks for financial institutions and were introduced to make lending rates more transparent, they differ in their essence.
To understand the point of distinction between these two benchmarks, individuals need to find out what is MCLR and base rate and their underlying concepts.
What is MCLR?
MCLR is the minimum rate of interest below which financial institutions cannot offer loans to borrowers. However, there are certain exceptions approved by RBI wherein lenders may extend loans below this set threshold.
Under this regime, financial institutions can provide different loans against fixed and floating rates of interest. The lending institutions factor in the prevailing MCLR to set the interest rate of different financial products and reset the credit limit.
Notably, MCLR is a tenor linked internal benchmark, and it is computed based on outstanding repayment tenor. Financiers weigh-in 4 crucial elements: tenor premium, the marginal cost of funds, negative carry on CRR, and operating cost to determine the marginal cost of funds based lending rate.
Note that the formula given below is used to ascertain the marginal cost of fund –
Marginal Cost of Fund = Marginal borrowing cost x 92% + return on the net worth x 8%
What is base rate?
This structure was introduced in 2010 to replace the benchmark prime lending rate. It was introduced to streamline the transmission of monetary policies and increase transparency in setting interest rates. However, later it was replaced by MCLR on the same grounds and further increased overall transparency in the lending system.
Unlike the MCLR rate, factors like the average return of net value, margin of profit, operating cost, and undistributed overhead expenses are considered to compute the base rate.
Other than these, several points of distinctions separate the base rate from its successor MCLR. This section below covers the same in brief.
MCLR vs base rate
Here is a list of differences between MCLR and base rate –
- Link with the repo rate
When compared to the base rate, MCLR is more closely linked with the repo rate. Therefore, any change in the same reflects much faster on the marginal cost of funds based lending rate. In turn, a change in repo rate directly impacts home loan floating interest rate and subsequently on borrowers’ EMI amount.
Individuals who are pre-equipped with the knowledge of MCLR and its effect on home loans can formulate strategies to cushion the changes triggered by repo and this rate structure.
Alternatively, base rate is not necessarily sensitive to changes in policy rates. This turned out to be quite disadvantageous for existing borrowers as they failed to avail the benefits associated with repo rate cuts. To remedy the situation, the RBI asked financial institutions to allow existing borrows to switch from base rate structure to MCLR at zero cost.
- Computation of interest rates
The tenor premium plays a vital role in computing the marginal cost of funds based lending rate. Notably, the tenor serves as the reset period; which means if the tenor increases, the reset period also increases.
Conversely, the base rate factors in return margin or minimum profit for the same purpose. The fact it does not factor in the tenor premium allows financial institutions to levy a higher interest rate on loans available for a longer tenor.
Ideally, intending borrowers of, say, housing credit can use a EMI calculator for home loan to understand how the repayment tenure influences loan interest rates.
- Tenor of benchmark
Individuals must note that MCLR rate depends on the loan tenor. Conversely, financial institutions have the leeway to reset the base rate quarterly.
Ideally, the MCLR structure proves to be effective in more than one way. Nevertheless, to simplify the borrowing experience further, individuals should consider availing of a loan from financial institutions that extend simple repayment terms and levy competitive rates.
Generally, leading financiers extend pre-approved offers that make the borrowing process more streamlined. Such offers can be availed on financial products like home loans and loans against property. Check your pre-approved offer online with your name and contact number.
Additionally, existing borrowers must note that once they switch to the MCLR structure, they cannot switch back to the base rate structure. This means they should weigh all pros and cons of what is MCLR to make an informed decision.