Is MCLR Better than Base Rate for Homebuyers?

With RBI cutting the repo-rate by 35 basis points in August 2019, the marginal cost-based lending rates of financial institutions have also lowered by quite a margin. This reduction of MCLR has reflected on the interest rate for various advances offered by lenders across India. Under this new MCLR-based regime borrowers can enjoy a considerably lower interest rate than what they were paying before. 

The system of marginal cost-based lending rates came into operation in 2016. But before that lenders used a base rate to levy the interest rates on advances. This base rate was determined according to the average cost of funds and the minimum rate of return. 

There is a significant difference between these two systems of levying interest rates. Following is an analysis of both these regimes and understanding which one is better for homebuyers to avail. 

What is the base rate, and how was it calculated? 

Before the MCLR based home loans were offered by lenders, every advance made available used to fall under the purview of base rates. This system came into operation from 2011, and until 2016, every financial institution had to follow it mandatorily. 

Base rate is determined using the following factors – 

The average cost of funds. This average cost helps determine the interest rate on deposits. 

The operating costs or unallocated costs which include components like depreciation, legal expenses, cost of stationery, administrative costs, etc. 

The negative carry from cash reserve ratio that financial institutions need to incur to maintain a certain cash reserve with the RBI. 

A profit margin from the net amount obtained. 

How is the marginal cost-based lending rate calculated? 

Before learning the calculation of interest rates under this regime, you must first understand “what is MCLR.” It is the minimum interest that a financial institution must levy to lend advances. Lenders cannot grant interests lower than this rate for any of their financial products. 

To learn about MCLR and its effects on loans, you first need to understand the factors that determine this system. These are – 

# Marginal cost of funds which comprise of the summation of cost of marginal borrowings and return on net worth. In sum, the cost of marginal borrowings comprises of 92% while the return on net worth includes the remainder of 8%. 

# Cost of operating, including costs associated with raising funds, providing loans, running daily operations, etc. 

# Cash deposits that financial institutions have to maintain with the Reserve Bank of India. 

# Tenor premium, which is charged on long term loans and helps to mitigate risks that come with long term lending. 

Under this system of lending, financial institutions have to mandatorily declare their interest rates every month. Thus, for borrowers, it becomes easier to track the lending rates of financial institutions from their websites. 

Therefore, this lending system provides a level of transparency between the lenders and borrowers, making it much more beneficial than the base rate for individuals looking to avail advances under the regime. 

Is the MCLR system better than base rate system? 

Introduction of marginal cost-based lending rates has made it much simpler and convenient for prospective home buyers to avail a home loan. They can now avail the benefits of the various policy implementations like changes in the RBI repo rate, without any hassle. Thus, it is better for borrowers to shift from the base rate system to marginal cost-based lending rates system. 

Therefore, to maximise the benefits from your home loan, it is best to shift from base rate to the marginal cost-based lending rate. However, if you are planning for a home loan transfer make sure you check the MCLR rate. Also, before switching check the additional related charges levied to make sure you don’t end up paying more than you save.