High interest rates can often be a burden when taking a loan, leading borrowers to repay much more than the borrowed amount. To address this issue, the MCLR came into the picture. The MCLR’s full form is the Marginal Cost of Funds-Based Lending Rate, representing the minimum interest rate a lending institution typically charges.

Understanding what is MCLR exactly is important for every borrower to better understand their loan terms. At its core, MCLR is a system introduced to improve transparency in the rate of interest calculations for loans. In this article, we will understand in depth the MCLR meaning or MCLR definition, along with how it is calculated.

Table of Contents

• What Is the MCLR Rate?
• Why Was MCLR Introduced?
• How Does the MCLR Influence the EMIs?
• How Is MCLR Calculated?
• Conclusion

What Is the MCLR Rate?

MCLR is the minimum lending rate below which financial institutions cannot lend. Implemented by the RBI on 1 April 2016, MCLR replaced the earlier base rate system.

To understand the MCLR rate meaning, it’s important to know that it serves as an internal reference rate for lending institutions to determine the rate of interest on loans. The calculation of MCLR involves the consideration of the marginal cost of funds, which includes the interest rate offered on deposits, borrowing rates, and the cost of maintaining the Cash Reserve Ratio (CRR). It also considers the tenor premium or tenure premium which accounts for the risk associated with the loan term.

This funds-based lending rate system ensures more accurate and fair rates by reflecting the actual cost incurred by financial institutions in arranging additional funds.

Why Was MCLR Introduced?

The RBI introduced the MCLR system to replace the ineffective base rate system. The aim was to create a more responsive, standardised, and transparent system. The difference between MCLR and base rate is that the latter is based on the average cost of funds and is slower to respond to market conditions. Moreover, the base rate was a single rate for all types of loans, offering less flexibility. MCLR provides financial institutions with more flexibility to set different rates for different tenures of loans such as home loans.

With MCLR, changes in the RBI's rates quickly reflect in the rate of interest lenders offer, ensuring fair minimum interest rates. The shift from base rate to MCLR allows banks to compete better and supports economic growth, benefiting both lending institutions and customers.

How Does the MCLR Influence the EMIs?

The MCLR significantly influences EMIs. As a cost-of-funds-based system, it determines the minimum interest rate financial institutions can charge. When the MCLR changes, the interest rate on loans linked to it also adjusts. A lower MCLR results in lower interest rates and, thus, lower EMIs for borrowers.

Conversely, a higher MCLR leads to higher interest rates and EMIs. This dynamic ensures that the loan's cost aligns with the lender's marginal cost of funds, making the pricing of loans more reflective of the actual costs incurred by lenders.

It is important to remember that other factors like the borrower's credit score and loan tenure can affect the final interest rate offered by the lender.

How Is MCLR Calculated?

To understand how to calculate MCLR, it is essential to break down its primary components and the process involved.

1. Tenor Premium

The tenor premium is an important factor in calculating MCLR. It reflects the risk associated with the duration of the loan. When the loan period is longer, the risk for the lending institution is higher. To manage this risk, lenders charge an extra amount called the tenor premium. This premium varies depending on the loan's duration, making sure that the risk is factored into the interest rate appropriately.

2. Marginal Cost of Funds (MCOF)

The marginal cost of funds represents the average rate at which deposits of similar maturities were raised during a specific period before the review date. This cost is reflected in the financial institution’s outstanding balance. The marginal cost of funds is divided into:

• Marginal Cost of Borrowings
• Return on Net Worth

3. Operating Cost

The operating cost comprises the expenses associated with raising funds, excluding costs recovered separately through service charges. It is directly linked to providing the loan product, encompassing expenses such as administrative costs and overheads related to loan processing.

4. Negative Carry on Account of CRR

A negative carry on the Cash Reserve Ratio (CRR) happens when the return on the CRR balance is zero or less than the cost of funds. This situation negatively impacts the Statutory Liquidity Ratio (SLR) balance that every commercial bank must maintain.

The negative Carry on Cash Reserve Ratio is calculated using the below formula:
Required CRR * [Marginal Cost / (1-CRR)]

Process of Calculation

To calculate MCLR, financial institutions follow a structured approach that integrates the aforementioned components:

• The financial institutions first determine the marginal cost of funds based on their borrowing and deposit costs.
• The total operating costs associated with raising funds and providing loan products are calculated and added to the marginal cost of funds.
• A tenor premium is added to the cost of funds based on the loan duration. This premium ensures that the rate of interest reflects the risk associated with the loan's tenor.
• The negative carry due to CRR is included in the calculation to account for the non-earning portion of the reserves.

Thus, MCLR = MCOF + Operating Costs + Tenor Premium + Negative Carry on CRR

Conclusion

Knowing what MCLR is and how it is calculated can help borrowers get a better understanding of the loan terms and the interest rates they get. The primary motive of MCLR is to ensure that everything is fair between lending institutions and their borrowers when they offer them a loan.

SMFG Grihashakti upholds these fair lending practices by offering home loans at affordable interest rates for eligible borrowers. You can learn more about our home loan interest rates here and use our free online EMI calculator to better understand the impact of monthly payments on your wallet.