Tuesday 30th August 2016
Understanding MCLR and its Effects on Home Loans
The Reserve Bank of India (RBI) changes rates to increase or decrease the flow of money in the economy. During inflation, RBI policy is to decrease the flow of credit in the economy and leave end user with less money to spend. Consequently, the end user will demand less and a lower demand will decrease the price of goods and services and thus, inflation will be curbed. Similarly, during deflation, RBI wants to increase the flow of credit in the economy to increase the price of goods and kill deflation.
Repo rate is an important tool of RBI to increase or decrease the flow of credit in the economy. Repo rate is the rate at which RBI lends to commercial banks. When RBI wants to increase the flow of credit, it decreases the repo rate so that it becomes easy and cheap for commercial banks to borrow from RBI, which leaves commercial banks with more funds to pass on to the end user by giving them loans. This ultimately leaves end users with more money and hence, the credit flow in the economy increases. Conversely, if RBI wants to decrease the flow of credit, it increases the repo rate which makes it difficult for commercial banks to borrow and thus, lend further.
Problem with Base Rate
Until March 31 2016, commercial banks used base rate as their benchmark rate to lend loans to public. Base rate is the minimum rate at which commercial banks lend to public and the rate can’t be lowered even if the tenure is very less. Different banks have different base rates*(here in this article, I would mean SBI’s base rate whenever I mention base rate). RBI changes repo rate to pass it on to the end user. From March 2010 to June 2015, RBI has changed (particularly increased) repo rate 24 times, which means RBI has been wanting to decrease the flow of credit in the economy to control inflation. The flow of credit will reduce only if base rate is increased in response to an increase in repo rate because the end consumer has more to do with the base rate. However, SBI has changed its base rate only 14 in response to change in repo rate 24 times. It is clear that the effect of change in repo rate was passed on to the end user very slowly and the whole idea behind changing repo rates could not take good shape.
On 1st April 2016, Marginal Cost of Fund Based Lending Rate (MCLR) was introduced by RBI, as a modification to the existing base rate system. Now, commercial banks will lend loans to new consumers at the MCLR instead of base rate. Existing borrowers can also shift to the new MCLR regime. They should do this because MCLR will pass on the benefits of repo rate cut to the borrowers. It has been made mandatory for commercial banks set different MCLRs for different tenure of loans ranging from overnight to yearly. Banks can also set quarterly and half yearly rates and even for many years. Now, if a person gets a loan on the quarterly MCLR, his interest rate will change in every three months, which will change his installments quarterly.
Effect of MCLR on Home Loans
Home loans are generally long term loans. If a home loan is granted on a yearly MCLR, the rate will change after one year and remain fixed during the year. So, if repo rate increases during the year, the MCLR will not increase in response, benefitting the borrower because he will have to pay a lower amount on installments. RBI decreased the repo rate by 25 basis points on April 5, 2016. Since, MCLR are designed to change quickly in response to change in repo rate, MCLR has also declined. It means that home loans have gone cheaper. If a borrower is able to secure a home loan at yearly MCLR, he will continue to pay installments at the low rate at which he got the loan, for one year, even if repo rate and MCLR rise in future. Hence he will be able to enjoy the benefits of a cut in repo rates and RBI’s motive of increasing the demand will be fulfilled.
Why should you think before going for MCLR
Although MCLRs are set lower than the base rates, commercial banks have a power to add spread to the rate. Depending on the riskiness of the borrower banks could add a spread over and above the MCLR, thus increasing the rate and refuting the whole idea of transferring the benefits of repo rate cuts to the end consumer. Moreover, the conversion fees for existing borrowers to get transferred to the MCRL regime from the base rate regime ranges from 0.5-1% of the total loan amount, making the whole affair expensive. Thus, the move to shift to the new MCRL regime must be well calculated.