How Do Banks Fix the Rate of Interest – The MCLR Concept

As soon a person starts earning a regular income, the two common thoughts that come to their mind are – a) When shall I buy my own house, and b) From Where Can I Get a Home Loan?

You can browse the internet and search for the best housing loan products of all banks. Naturally, you start comparing the interest rates of the individual banks and NBFCs (Non-Banking Financial Companies). You find an intriguing aspect. Banks advertise their Home Loan interest rate as MCLR or MCLR + 1% and so on. What exactly is the MCLR? Let us look at the concept in brief and understand how banks fix the rate of interest on their home loan and other loan products.

The MCLR Concept

MCLR refers to Marginal Cost of funds based lending rate. It is the minimum rate below which no bank can lend to its customers, except some individual cases. You can also refer to it as the internal benchmark rate or reference rate for a bank.

MCLR describes the method by which the bank determines the minimum interest rate for loans. It depends on the marginal cost of arranging one more rupee to the prospective borrower. A lot of factors go into the computation of the MCLR. We shall look into them briefly.

MCLR Rate – The Introduction

The Reserve Bank of India (RBI) introduced the concept of MCLR with effect from April 01, 2016. Before that, the banks were following the Base Rate methodology from July 2010. Before July 2010, there was the BPLR (Benchmark Prime Lending Rate concept). Loans sanctioned before April 01, 2016 would continue under the existing arrangement (Base rate or BPLR concept) until their repayment. However, borrowers can opt to shift to the MCLR concept at mutually acceptable terms.

Why is MCLR Concept Preferred?

RBI shifted to the MCLR concept because the MCLR is sensitive to the changes in the policy rates, so essential for the implementation of the Monetary Policy. The primary objectives of introducing this conceptare as follows:

• Facilitate and improve the transmission of policy rates into the lending rates of the banks
• Transparency in the methods that banks follow for determining interest rates on loans
• Ensure availability of bank credit at rates fair to both the banks and the borrowers
• Usher in more competition among the banks and enhance their contribution to the economic growth of the country

MCLR – The Computation

The MCLR is a tenure-linked internal benchmark. The amount of time left for the repayment of the loan is the tenure. The MCLR is not the actual lending rate. The banks add their spread over the MCLR. It explains why you have rate structure as MCLR + 1% or MCLR + 2% and so on. Banks have to review the MCLR and publish them every month on a pre-announced day.

Let us see how the banks compute the MCLR. It is a complicated calculation.

MCLR comprises of the following factors.

1. Marginal Cost of Funds: A combination of the marginal cost of borrowings and the return on net worth, appropriated weighed.

Marginal Cost of funds = (92% X Marginal cost of borrowing) + (8% X Return on Net worth)

The weight given to the Return on Net Worth = 8% of the Risk Weighted Assets of the particular bank.

The marginal cost of borrowing is the average rates at which the bank raises deposits of similar maturity in the specified period preceding the review date weighed by the outstanding balance in the bank’s books. In simple terms, the marginal cost of borrowing is directly proportional to the rates banks offer on their incremental deposits.

2. Negative Carry on Account of Cash Reserve Ratio (CRR): Banks do not get any interest on the mandatory deposits they park with the Reserve Bank of India as CRR.

3. Operating Cost: Costs that banks incur on providing various loan products excluding the costs covered by way of service charges.

4. Tenure Premium: It is uniform for all types of loans for a given residual tenure. It is not borrower specific or loan category-specific.

Banks have to publish the MCLR for the following maturities:

• Overnight MCLR
• One-month MCLR
• Three-month MCLR
• Six-month MCLR
• One year MCLR
• MCLR for any other tenure that banks deem fit

Actual Lending Rate

Banks add their spread to the MCLR and fix their interest rates. They cannot lend below the MCLR of a particular maturity for all loans linked to that benchmark.

MCLR – Loans Excluded Under the Concept

• Fixed rate interest loans above three years
• The government of India-formulated special loan schemes
• Loans sanctioned to depositors against their fixed deposit
• Advances to bank’s employees

One can conclude from the above that MCLR depends on the performance of the bank under all parameters. Banks will not be able to mobilise depositsat extraordinary rates of interest as it can affect their MCLR adversely. It brings in the sense of equality among all banks. Note that the MCLR concept does not apply to NBFCs.