How to become well versed in the Concept of MCLR in Home Loans

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30 AUGUST, 2019

In 2016, the Reserve Bank of India incorporated the Marginal Cost of Funds based Lending Rates (MCLR). The goal of MCLR was to ensure the effective transmission of fluctuating interest rates to all customers. Banks are obliged to fix their lending rates basis MCLR.

After the introduction of MCLR, many people started wondering whether they should switch to MCLR based loans from their existing loan. As the concept is new, people are still confused about it and finding it difficult to understand the terms used in it.
Let’s first understand the reason behind the incorporation of MCLR,
Before MCLR, the Base Rate system was used to define interest rates on all types of loans including home loan interest rates. The base rate system had some drawbacks like the repo rate and other borrowing rates were not avowed under the base rate system; that’s why the Government removed it and introduced MCLR.

The interest rates are the combination of base rates and Spread. The base rate is the lending rate below which banks were not allowed to lend the money to their customers. Moreover, there is also a term called Spread, which is over and above the base rate. So, if the base rate of a bank is 9% and Spread is 0.5%, then the interest on the loan is 9.5%.

With Base Rate systems banks used to take a long time to respond to falling interest rates. As a result, customers were not benefited from the low-interest rate, despite the reduction in the interest rate by the RBI.

The relation between MCLR and Home Loan
Understanding the concept of MCLR in home loans is important because home loans are one of the most important financial commitments in a person’s life. The MCLR was introduced to benefit every borrower in the country.

As the impact of MCLR is only limited to floating interest home loans, it is generally advised to get floating interest rates when opting for home loans (if in case interest rates are expected to go down in market). The readers need to understand that the fixed-rate home loans are not affected by MCLR at all. Floating interest rates are made of two components,

MCLR which stays constant for a certain period called as reset period. Ex: If a loan is taken on a 1 year MCLR then MCLR remains constant for 1 year for that loan and then gets reset basis the prevailing rates. Similarly, if loan is taken on 6 month MCLR then MCLR remains constant for 6 months for that loan and then gets reset post 6 months basis the prevailing rates.
A variable floating component called as Margin or Spread which remains constant throughout the tenure of the loan

The EMI of floating rates home loans consists of fixed principal amount and interest amount which is dependent on the floating interest rate. Thus, EMIs on home loans with the floating rates are subjected to change as per the interest rates.

Whether the borrower will be benefited from the change in the interest rate provided by the bank is influenced by the reset period and the Repo Rate. As RBI cuts the Repo rate, MCLR comes down post the reset period (for that loan) and hence interest rate on home loan will also come down

How to become well versed in the concept of MCLR in Home Loans?

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