MCLR Full Form-Marginal Cost of Funds Based Lending Rate

Marginal Cost of Funds Based Lending Rate (MCLR): Definition, Calculation, and Impact on Borrowers

Introduction

The Marginal Cost of Funds Based Lending Rate (MCLR) is a key benchmark in the Indian banking system that determines the minimum interest rate at which banks can lend. Introduced by the Reserve Bank of India (RBI) in April 2016, MCLR replaced the previous Base Rate System to improve transparency and ensure a faster transmission of monetary policy changes to borrowers.

This article explains what MCLR is, how it is calculated, its impact on borrowers, and how it differs from other lending rate mechanisms.

What is the Marginal Cost of Funds Based Lending Rate (MCLR)?

MCLR is the minimum interest rate set by banks for lending to customers. It is based on the cost of funds and is influenced by repo rates and other factors. Banks cannot lend below the MCLR rate except in specific cases allowed by RBI regulations.

The introduction of MCLR aimed to ensure that when the RBI changes key policy rates, banks pass on these changes more efficiently to borrowers, leading to fairer interest rates.

How is MCLR Calculated?

MCLR is determined by multiple components, ensuring that lending rates reflect the actual cost of funds for banks. The key elements used in calculating MCLR are:

1. Marginal Cost of Funds

The weighted average cost of new deposits and borrowings taken by banks. It includes the interest paid on savings accounts, fixed deposits, and borrowings from RBI. The repo rate plays a significant role in determining this component.

2. Negative Carry on Cash Reserve Ratio (CRR)

Banks are required to maintain a Cash Reserve Ratio (CRR) with the RBI without earning any interest. This results in a cost for banks, which is factored into MCLR calculations.

3. Operating Costs

Banks incur costs for maintaining banking operations, such as employee salaries, branch maintenance, and IT infrastructure. These operational costs are included in MCLR.

4. Tenor Premium

The tenor premium reflects the risk of lending for different durations. Loans with longer tenures typically have a higher interest rate to compensate for the increased risk.

The formula for MCLR is:

MCLR = Marginal Cost of Funds + Negative Carry on CRR + Operating Costs + Tenor Premium

How MCLR Affects Borrowers

1. Impact on Home Loans and Other Loans

MCLR significantly influences interest rates on home loans, auto loans, and personal loans. A lower MCLR leads to reduced EMIs for borrowers, making loans more affordable.

2. Effect of RBI Policy Changes

When the RBI reduces the repo rate, the marginal cost of funds for banks decreases, leading to a lower MCLR. This results in reduced lending rates, benefiting new borrowers and those with floating-rate loans linked to MCLR.

3. Loan Tenure and Interest Rate Fluctuations

Borrowers with loans linked to MCLR benefit from lower rates when banks revise MCLR downward. However, during periods of increasing interest rates, loan EMIs can also rise.

4. Transparency and Fair Pricing

MCLR ensures that borrowers receive fair and market-driven interest rates. It prevents arbitrary pricing by banks, making loan interest rates more competitive and transparent.

MCLR vs. Base Rate vs. Repo-Linked Lending Rate (RLLR)

• MCLR

Introduced in April 2016, MCLR is based on the marginal cost of funds and offers faster transmission of monetary policy changes compared to the base rate.

• Base Rate

The base rate, introduced in 2010, is based on the average cost of funds, and its transmission of RBI policy changes to borrowers is slower.

• Repo-Linked Lending Rate (RLLR)

Introduced in October 2019, RLLR is directly linked to the RBI’s repo rate, offering immediate transmission of changes to borrowers. It is the most transparent lending rate system.

Transition from MCLR to Repo-Linked Lending Rate (RLLR)

While MCLR improved upon the base rate system, it still had delays in transmitting monetary policy changes. To further enhance transparency and quicken rate transmission, the RBI introduced the Repo-Linked Lending Rate (RLLR) in 2019. Loans linked to RLLR change automatically when the RBI revises the repo rate, making the system even more efficient.

How Borrowers Can Benefit from MCLR-Based Loans

1. Choose Floating Rate Loans Linked to MCLR

Floating-rate loans adjust periodically based on MCLR changes, helping borrowers benefit from lower rates.

2. Monitor MCLR Announcements by Banks

Borrowers should stay updated on their bank’s MCLR revisions to understand how their loan EMIs may change.

3. Consider Balance Transfer if Lower MCLR is Available

If another bank offers a lower MCLR, borrowers can transfer their loans to take advantage of lower rates and reduce interest costs.

4. Opt for Shorter Reset Periods

MCLR-linked loans typically have reset periods (e.g., 6 months or 1 year). Choosing a shorter reset period ensures quicker adjustments when MCLR decreases.

The Marginal Cost of Funds Based Lending Rate (MCLR) is an essential mechanism for determining loan interest rates in India. By ensuring that banks pass on the benefits of RBI’s policy rate changes to borrowers, MCLR has improved transparency and efficiency in the financial system. However, with the introduction of Repo-Linked Lending Rates (RLLR), borrowers now have an even faster way to benefit from changes in the RBI’s monetary policy.