Marginal Cost of fund-based Lending Rate (MCLR) is the minimum interest rate below which a bank cannot lend to its customers, other than in cases of special exceptions that are approved by the Reserve Bank of India (RBI).
It is an internal benchmark rate that a bank or lender will refer to before deciding an interest rate. The MCLR system replaced the 'base rate' system on 1 April 2016. The system takes into consideration the additional cost of arranging every extra rupee for the loan applicant.
How is MCLR calculated?
The MCLR is based on a range of elements in order to not restrict the use of the tool. The four major elements include:
1. Tenure premium: The MCLR is different for different tenures as the cost of lending to will vary as per the tenure of the loan. The higher the tenure, the higher the risk associated with it, and to cover this risk the lender will shift the burden to the borrower by charging a premium. This premium is known as tenure premium.
Ideally, there will be uniformity in the tenure premium irrespective of the class of loan or borrower.
2. Operating Cost: This is the cost the lender incurs to raise the funds to provide as a loan. They will not only include the costs recovered from services charges but those simply associated with the product, that is, the loan.
3. Marginal Cost of Funds: This element includes Marginal Cost of Borrowing and Return on Networth. Marginal Cost of Borrowing, in simple words, is the interest paid by the banks to its customers that make deposits and the rate of interest the bank pays to the RBI for money borrowed. These are weighed into the MCF in a 92:8 ratio where the weightage of marginal cost of borrowing is 92 percent and that of the return on net worth is 8 percent.
4. Negative Carry on account of CRR: CRR or Cash Reserve Ratio is a proportion of the bank's fund that banks in India are supposed to submit to the RBI in form of liquid cash, mandatorily. It is accounted for negatively as this money cannot be used by the bank to make any income and does not earn interest.
Difference between the Base Rate and MCLR
Base rate was first introduced by the RBI in 2010 and later replaced by the MCLR in April 2016.
The reason to make the transition was the transparency that MCLR provides when compared to the base rate which comprises of lesser components.
- With a wider range of unique elements like those mentioned above, MCLR is more inclusive.
- Unlike MCLR, base rate did not include tenure premium which allows banks to charge a higher interest rate on loans that are long-term.
- The marginal cost of funds, which MCLR is largely based on, includes repo rate, which was not used in arriving at a base rate. Repo rate is the rate charged by RBI to commercial banks when they borrow funds from the central bank. This rate is decided by the central bank based on the status of the country's economy. Former RBI governor Dr. Raghuram Rajan suggested the MCLR strategy so that the change in repo rate (which is decided by the Monetary Policy Commitee every quarter) is reflected in the interest rates at which banks lend. This way the customers can benefit from the change in a faster and direct manner.
- The base rate on the other hand was not sensitive to the changes in monetary policies (repo rate). It was based on cost of funds, operating expenses, CRR and rate of return.
- Base rate was set by the RBI and MCLR is set by the banks themselves based on their business strategy. This means that borrowers can benefit for competitive interest rates and get loans at a cheaper rate.
There are existing loans that are based on the Base Rate (loans sanctioned till 31 March 2010) and Benchmark Prime Lending Rates (loans sanctioned till 30 June 2010) and will remain the same till repayment or renewal. However, these borrowers have the choice to link their loans to MCLR at mutually agreed terms with the lender.