After demonetisation, banks are offering lower floating rates on Home Loans under MCLR. Switching your loan to MCLR may be a good idea.
A fall in loan interest rates post demonetisation has taking out a loan easier. The shift in the lending rates setting from base rate to the Marginal Cost of Funds based Lending Rate (MCLR) has also made Home Loans cheaper. So what is MCLR? The Reserve Bank of India introduced MCLR for setting interest rates on loans in April last year.
For a better understanding of MCLR, it is important to understand base rate first. The base rate is the minimum rate of interest a bank charges customers who take loans. No bank can offer you a loan at an interest rate lower than its base rate.
MCLR is calculated on the marginal cost of funds, tenor premium, operating expenses and the cost of maintaining the cash reserve ratio. The base rate is then obtained on the basis of MCLR calculations.
Banks shifted from the base rate to MCLR in April last year. MCLR is thus the new benchmark lending rate at which banks lend to borrowers. It being lower than the base rate translates to cheaper Home Loan rates.
MCLR Lending Rates Make Home Loans Cheap
Till March 31st 2016, banks used the base rate as the benchmark rate for floating rate loans. Now, banks are using MCLR, which is lower than the base rate, and this makes your loans cheap. Floating interest rate on loans is one which changes with a change in the market conditions.
It is important to understand the terms used in the calculations of MCLR to better understand it.
The Marginal Cost of Funds
Let’s first understand what is meant by cost of funds. Sometimes, banks have to borrow to meet expenses of their business. They pay interest on this borrowed money called cost of funds.
Marginal cost is the additional cost banks incur to fund the purchase of an asset or make an investment.
For example, a bank has to make an investment and the cost of this investment is Rs. 1,000. Due to some reason, the bank’s expenses on this investment increase to Rs. 1,500. This additional cost (Rs. 500) is the marginal cost of funds.
the tenor is the amount of time left for the repayment of the loan. Different loans have different tenors or time periods. Under MCLR, if the bank lends for a higher tenor then there is a lot of uncertainty/risk associated with the lending. To make up for this risk, banks are allowed to charge a tenor premium.
Banks incur these expenses for providing a loan product minus the service charges.
Cost Of Maintaining The Cash Reserve Ratio
According to RBI rules, banks have to maintain a certain percentage of their total deposits with RBI in current accounts. This is cash reserve ratio also called CRR. Banks incur costs to maintain CRR.
MCLR is very closely linked to the actual deposit rates banks pay customers/depositors. So MCLR is much lower than the base rate.
How Does MCLR Make Home Loans Cheap?
Banks have a six-month or one-year MCLR as the benchmark rate on floating rate loans. If you choose the six-month MCLR, your home loan rates will be reset every six months.
Let’s say you take a Home Loan of Rs. 32 lakhs from a bank at one-year MCLR of 9.25% on April 1st 2016. This loan has a spread of 0.25%. (Banks charge a spread depending on your creditworthiness. So, maintain a good Cibil Score). Your Home Loan will be 9.5% (9.25% + 0.25%). You will have to pay your Home Loan instalments at this rate for a year.
On April 1st 2017, the bank revises the one-year MCLR to 9.2%. The spread remains constant at 0.25%. Your Home Loan interest rate gets revised to 9.45%. So your Home Loan gets automatically resets on this date. MCLR is a very good option if interest rates are going down.
Banks are offering lower floating rates on Home Loans under MCLR after demonetisation. Switching your loan to MCLR may be a good idea now. Do consider the costs of loan transfer or switching to a floating rate from a fixed rate. And if you are still saving then go ahead and switch your Home Loan.