Our Central Bank (RBI) sets a minimum rate for loan borrowers below which banks are not allowed to lend money that is termed as Base rate. This was done to ensure that the customers would receive lower cost of funds with transparency in the credit market.
Why use it over Base rate for loan computation?
Till 1st April 2016, banks were using Base rate (introduced in the year 2010) for calculating interest on loan. This replaced the previous concept named BPLR (Benchmark Prime Lending Rate) which was introduced in the year 2003. The latter one carried criticism that banks charged high interest rate for retail customers thereby subsidizing corporate borrowers.
Below listed points explain why MCLR score better over Base rate:
1) Base rate Lacks Transparency in the calculation on interest rate.
2) Another drawback on this Base rate is, all banks did not carry similar rate of interest. There was skewed computation been considered in base lending rate.
3) It did not consider Current and Savings deposit rate of interest but considered only Fixed Deposit ROI towards calculation.
4) Added to this, it also did not take into factor the cost of borrowings from RBI.
5) Central Bank lent free hand to banks to use any method for calculating base rate either by considering average cost of funds or marginal cost of funds or blended cost of funds.
6) Base rate was least sensible to change in the Repo rate which happens during monetary policy announcement.
Hence uniformity in the lending rate by different banks was brought in through MCLR as governed by RBI.
How does the banking borrowing system work
RBI is the apex of the Indian Banking system, under which there are the commercial banks which includes Public sector and Private sector banks, foreign banks and local area banks which includes rural banks and co-operative banks. The best way to know the business of banking is through a perusal of a typical bank’s balance sheet. This statement is the financial health check of bank which reflects Assets and Liabilities of banks at a particular point of time.
Also, usages of bank funds can be viewed in this balance sheet. Banks capital fund is sourced in the form of Fixed Deposit, Savings account and current account, borrowings from RBI and Equity funds from the owners of the shareholders. These borrowings form the liabilities of the bank. Through this borrowings, banks grant Loans, invest in securities, purchase equipment and hold cash items such as currency and deposit in other banks. These constitute Assets of Bank. Hereby Assets of banks are indications of what the bank owns or claims on external entities like individuals, firms, governments etc.. On contrary, liabilities are indications of what the bank owes as claims which are held by external entities of the bank. Hence net worth / Capital of any commercial banks is calculated by subtracting Total Assets from Total Liabilities. These assets and liabilities of banks need to be managed by banks to maximize the profits.
The Major list of Liabilities of the Banks are Capital and reserves, Deposits, borrowing from other sources, Contingent Liability, Profit or Loss. These are the funds obtained by banks in the form of debt primarily used to make loans and purchase securities.
Banks work like other business firms to strive for profit. The borrowed funds are primarily used to purchase income earning assets, mainly loans and investments. These assets are reflected in the balance sheet statement of the bank in decreasing order of the liquidity. Following are the major assets of the bank: Cash, Money at call and Short notice, Loan and Advances, Investments, Bills Receivable and Other Assets.
RBI has brought in a new methodology by which banks are allowed to lend home loan to new borrowers through internal benchmark lending rates termed as MCLR.
Why was MCLR over base rate introduced – What was the need for the same
Many a time we have come across interest rate cuts through monetary policy carried out by RBI. But banks were reluctant to pass this benefit to borrowers. In order to achieve the desired objectives of better monetary transmission, transparency and fair treatment RBI wanted the banking interest rates to penetrate into the economy at a faster pace.
Hence the MCLR regime came into existence
With effect from 1st April 2016, the home loan interest rates have been replaced by MCLR (Marginal Cost of funds based Lending Rate), as mandated by RBI. As India is one of the Emerging economies, we need to incorporate monetary transmission in our system at par with our global partners. MCLR carries 4 components for computation:
a) Marginal cost of funds
b) Negative carry on Account of CRR (Cash reserve Ratio)
c) Operating Costs
d) Tenor Premium.
Marginal cost of borrowing is cost of borrowings and return on net worth for banks. Marginal cost of borrowing has weightage of 92% while return on net worth has weightage of 8%. Thus formula goes like this: Marginal cost of Funds = (92% * Marginal cost of borrowing) + (8% * return on net worth)
Negative CRR (Cash Reserve Ratio which banks have to hold as reserves or deposit with central bank) as balances kept with the RBI does not carry any return hence it is called as negative carry on the CRR. The Negative carry on CRR is calculated like, Negative Carry = (Required CRR*Marginal Cost)/ (1-CRR)
Operating cost is the costs involved in raising funds. Since this is not a part of the Loan it will charged separately and recovered as service charges. Expenses such as salaries paid to staff, branch rent or other expenses which are not directly charged to customers are included under this head.
Tenor Premium arises from the committed loan with longer tenor. Higher the tenor higher the premium. This also refers to the reset of the interest rate for definite period. For a given tenor this remains same for types of Loans, in other words there would not be any borrower specific or product specific.
As per brokerage and investment group CLSA, the funding for these banks are done by domestic funding mix hence MCLR is directly linked with these deposit rates. For better understanding, if the prevailing one year Term deposit RoI is @7.50% then One year MCLR will be 7.50% + Negative CRR + Operating cost + Tenor Premium
In India, RBI’s monetary policy announcement deals with quantum of money flow and supply affecting rate of interest, inflation and asset prices. This event is currently happening every two months in a year or when situation demands for it. Any increase or decrease in the policy rates would make banks raise or lower the variable/ floating rate of Interest, thereby affecting EMI payable by loan buyers.
From the illustration shown below, you can understand the mathematics behind this monetary transmission and decide whether you would like to switch from existing Base rate to MCLR based type of loan. Here are the list of Components we consider for calculation:
Outstanding home loan amount
Outstanding tenor of the home loan
Differential rate of interest (For calculation purpose we assume this ROI as Fixed)
Note: Considering 0.5% as switching fee, it may vary from bank to bank. Increase in the savings on the Interest outgo is directly related with value of Loan amount, differential rate of interest and outstanding tenor.
Banks generally look for tenor adjustment by keeping EMI (Base Rate) unchanged. Let’s look at the calculation part and significance received by borrower in the given below table:
The above calculation reveals that reduction in the tenor is more beneficial than keeping original tenor unchanged. But the only drawback is, this is not assured as interest rates varies at the time of monetary policy announcement by RBI. Also, actual benefit can be known to the borrower only at the end of the loan tenor.
Should you switch to MCLR from Prevailing Base Rate?
It is evident from the above illustration that if the person had taken loan after July 1st, 2010 and before April 1st, 2016 where their loans are linked to base rate with rate of interest @10%, switching from their existing Base rate to MCLR will help old borrowers to save on the interest outgo. After the rate cuts announced by Banks, average MCLR has fallen to 8.75% and much lower creating differential spread of 1- 1.25% which will have impact on EMI and Interest components and on the tenor component as well. Also it is observed that longer the tenor more the benefit a person can receive. But moving from Base Rate to MCLR have several things to look out as mentioned below.
Things to Lookout before switching;
Once loan is switched to MCLR it cannot be moved back to Base rate.
After switching to MCLR, there will be upward risk in the interest rate reset by RBI during monetary policy announcement. If there is any change in the Repo rate, it will be reflected in corresponding MCLR rate.
People who have bought home loan before 1st April 2016 are with Base rates and have no option to switch to MCLR
If you feel banks offered MCLR rates are high then look out for refinancing from another bank which is offering lower rate of interest. There may be processing fee, lawyer’s fee, mortgage charge etc… been charged by bank. Please consider these costs in refinancing the loan.
In the given below chart, there are list of 34 major banks with their MCLR Bank Base rate tracker with various MCLR maturities tenor such as Overnight , One month, Three Month, Six Month and One Year.
Finally: From the given above calculations and information about the savings on interest and rate of interest from various banks, it’s time for the borrowers to decide whether to switch their loan from Base rate system to MCLR system keeping several look outs in mind. Historical data on these changes has quickly reflected on debt instruments like money market rates and Government bond yields unlike banks provided rate of interest. In an emerging market like India and government policies pertaining to housing sector there will be always scope for rate cuts in the near future. We are reiterating that final decision on switching over to MCLR should be considered on the basis of spread involved in that and additional loading involving switching fee /processing fee / transfer fee etc… Based on the above information one can take a prudential call.