When you apply for an education loan or any type of loan, the primary factor which you consider is the interest rate on the loan. Now, while comparing or checking the interest rate on loans, you might have come across the term ‘MCLR’. The bank uses MCLR while calculating and determining the effective rate of interest on loans. All the calculations are performed as per the guidelines of RBI. You should also understand what is RLLR as it is also used in the calculation of interest rates. Let’s understand what is the full form of MCLR, what are its outcomes, and how it is different from the base rate.
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What is the Full Form of MCLR?
The full form of MCLR is the Marginal Cost of Funds based Lending Rate (MCLR). It was introduced by the Reserve Bank of India (RBI) on April 1, 2016. MCLR serves as the minimum lending rate below which banks are not permitted to lend. It replaced the earlier base rate system, aiming to provide a more transparent and efficient way for banks to determine lending rates.
MCLR is an internal reference rate for banks that helps them decide the interest rates they can charge on loans. The rate is based on the incremental cost of arranging an additional rupee for a prospective borrower. This ensures that the cost of funds is accurately reflected in lending rates.
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MCLR Implementation and its Impact
The implementation of MCLR brought major changes to how interest rates are determined by the bank for loans. Under the MCLR regime, interest rates are adjusted based on the relative risk profile of individual customers. Before MCLR, when the RBI reduced the repo rate, banks were slow to pass on the benefits to borrowers. With MCLR, banks are required to adjust their interest rates immediately in response to changes in the repo rate.
This system aims to increase transparency in the structure used by banks to calculate interest rates on loans and advances. It ensures that bank credits are available at interest rates that are fair to both consumers and banks.
How to calculate MCLR?
MCLR is calculated based on the loan tenor, i.e., the duration for which a borrower must repay the loan. This tenor-linked benchmark is internal to each bank. The actual lending rates are determined by adding a spread to this benchmark rate. Banks declare their MCLR after a thorough examination, applying the same process for loans of different maturities, whether monthly or as per a pre-announced cycle. After all these criteria, the bank determines the effective rate of interest by adding MCLR and spread.
There are a total of four major elements of MCLR. These are made up of the following:
| Elements | Description |
| Tenor premium | The cost of lending varies with the period of the loan. Longer loan durations indicate higher risk, which banks mitigate by charging a tenor premium. |
| Marginal cost of funds | This element reflects the average rate at which deposits with similar maturities were raised before the review date. The marginal cost of funds includes components like the Return on Net Worth and the Marginal Cost of Borrowings, with the latter accounting for 92% and the former 8%, corresponding to the risk of weighted assets represented by Tier I capital for banks. |
| Operating Cost | Operational expenses are linked to raising funds, excluding costs recovered through service charges. These expenses are directly associated with providing the loan product. |
| Negative carry on account of CRR | A negative carry on the Cash Reserve Ratio (CRR) occurs when the return on the CRR balance is zero, leading to a negative impact when the actual return is less than the cost of funds. This affects the Statutory Liquidity Ratio (SLR) balance that every commercial bank must maintain. |
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How MCLR is Different from Base Rate?
MCLR is an upgraded version of the base rate which incorporates a risk-based approach to determine the final lending rate for borrowers. Unlike the base rate, MCLR considers the marginal cost of funds, which includes the repo rate. When calculating MCLR, banks must include all interest rates incurred in mobilising funds.
MCLR requires banks to account for the loan tenure by including a tenor premium. This allows banks to charge higher interest rates for long-term loans, a factor not considered under the base rate system.
Deadlines to disclose monthly MCLR
Banks must disclose their MCLR or internal benchmark according to specific deadlines, which can be one month, overnight, three months, one year, or any other maturity as deemed fit by the bank. All loan categories can be offered at fixed or floating interest rates, but the lending rate for any loan maturity cannot be below the MCLR.
However, some loans are not linked to MCLR, such as loans against customers’ deposits, loans to bank employees, special loan schemes by the Government of India (like the Jan Dhan Yojana), and fixed-rate loans with tenures above three years.
The MCLR system introduced by the RBI ensures a more transparent and fair method for determining lending rates, benefiting both borrowers and banks. You can now easily understand how the effective interest rate is calculated by the bank. Check some common FAQs based on MCLR.
FAQs
The full form of MCLR is the Marginal Cost of Funds based Lending Rate. Introduced by the Reserve Bank of India (RBI) on April 1, 2016, MCLR serves as the minimum lending rate below which banks are not permitted to lend.
MCLR is calculated based on the loan tenor, the duration for which the loan is to be repaid. Banks declare their MCLR after examining various factors, including the marginal cost of funds, operating costs, and the negative carry-on account of the Cash Reserve Ratio (CRR). The effective rate of interest is determined by adding a spread to this benchmark rate.
MCLR brought significant changes by incorporating a risk-based approach to determine the final lending rate for borrowers. Unlike the base rate, which did not account for the tenure of loans, MCLR includes a tenor premium, allowing banks to charge higher interest rates for longer-term loans.
The implementation of MCLR led to more immediate adjustments in loan interest rates in response to changes in the RBI’s repo rate. The system also customised interest rates based on the relative risk profile of individual customers.
Banks are required to disclose their MCLR according to specific deadlines, which can vary from one month to overnight, three months, one year, or other maturities as deemed appropriate by the bank.
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