Is Staying on MCLR Based Home Loan Beneficial?

Between February and October of 2019, Indian financial market witnessed record policy rate cuts, recorded to a drop of 135 basis points. However, the interest rate on various loans fell only by 44 bps. To lower the difference between market rates and offered interest rates, the Reserve Bank of India has made it mandatory for financial institutions to link the floating interest rate of their new loans to the current external benchmark, i.e. Repo Linked Lending Rate (RLLR).

This policy change was introduced to bring transparency into the market compared to the previous MCLR (Marginal Cost of Funds Based Lending Rate) based system. Furthermore, it also allowed transferring the policy rate cuts faster than before.

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

The RBI introduced this methodology in 2016, where financial institutions can decide the minimum interest rate according to their preference. Home loan MCLR rates are determined according to the tenor of a loan, and it acts as an internal benchmark. According to the financial institutions, more than 80% of loans with floating interest rates are still linked to MCLR.

This rate is closely related to actual deposit rates, and it is calculated based on four factors, tenor premium, operating cost, the marginal cost of funds, and negative carry on cash reserve ratio.

As mentioned before, one of the chief complaints against this process was that it lacked transparency. To mitigate such complaints, the RLLR was implemented. However, the RBI never specifically abolished the MCLR process, and both of these techniques are now in operations.

However, in its recent policy announcement on 6th February, the authorities did not revise the repo rate but took some initiatives to reduce the financial institution’s cost of funds. This measure is designed to benefit the customers, as financial institutions can lower their MCLR rate and offer loans at a reduced interest rate. RLLR, on the other hand, remained unchanged owing to no revision of the repo rate.

Should a borrower stay with MCLR?

Whether borrowers should stay with MCLR or not depends on their repayment capability. However, they should know that MCLR is usually revised annually.

Consider the following example to know about MCLR based home loans and decide better –

An individual availed a home loan in April 2019 when the home loan interest rate was 8.90%, and it has fallen to 8.40% in March 2020 when the revised rates were applied. On the other hand, if that individual now shifts to RLLR based home loans, the interest rate becomes 8.25%. Thus, after the reset, this difference becomes only 15 basis points.

RLLR (Repo Linked Lending Rate)

As the name suggests, this rate is linked with the Reserve Bank of India’s repo rate. For instance, if RBI’s current repo rate is 5.45% and it is lowered by 45 basis points to 5%, the RLLR will also get reduced by 45 basis points. On the other hand, if this repo rate increases, the RLLR will also increase accordingly as it is an external benchmark.

However, the interest rate of RLLR depends on various factors such as the loan amount, LTV ratio, risk quotient of the borrower, etc. Based on these factors, a financial institution decides the applicable spread or margin competitively. For example, the RLLR of a financial institution is originally 6.9%, but the actual loan is disbursed at 7.5%, of which 0.6% acts as the spread or margin.

Hence, shifting from MCLR to RLLR does not benefit this individual very much.

For borrowers who have loans linked to MCLR and are awaiting a revision in the next 2-3 months, it would be beneficial for them to stick to the MCLR in case the financial institution reduces their interest rate. On the other hand, if the loan has been revised already and they can observe the MCLR and its effects on loans, then switching to the other is the right decision.