Understanding MCLR vs. Base Rate: Which One Affects Your Loan More?

When we talk about loans, it is important to understand the mechanisms that determine interest rates. It directly impacts your borrowing costs. In India, there are two basic benchmarks which are being used by banks to set these rates which include the Base Rate and the Marginal Cost of Funds Based Lending Rate (MCLR). In this blog we delve into the meanings of these terms, their differences, and how these rates influence various loans like personal or gold loans.

Table of Content

• What is the Base Rate?
• Understanding MCLR
• What are the Key Differences Between Base Rate and MCLR?
• What is the Impact on Personal and Gold Loans?
• Moving from Base Rate to MCLR
• Conclusion

What is the Base Rate?

The Base Rate is the minimum interest rate set by commercial banks, below which they are not permitted to lend to customers. It was introduced by the Reserve Bank of India (RBI) in July 2010, the base rate system aimed to bring transparency to lending rates and ensure that banks pass on the benefits of reduced policy rates to borrowers.

There are certain factors that influence the base rate that includes the bank’s cost of funds, operating expenses, and a minimum margin to cover regulatory requirements and profit margins. 

Understanding MCLR

On April 1,^, 2016, RBI set the Marginal Cost of Funds Based Lending Rate (MCLR) as a benchmark lending rate by replacing the base rate system. The MCLR reflects the marginal (additional) cost of funds for banks, making it more sensitive to changes in the RBI's policy rates. It is calculated based on various components:

• Marginal Cost of Funds: It is also known as the repo rate, this fund includes the interest rates offered on deposits and the rates at which banks borrow from RBI.
• Operating Costs: Expenses incurred by banks in their day-to-day operations.
• Negative Carry on Cash Reserve Ratio (CRR): The cost that banks bear for maintaining the mandatory reserves with the RBI without earning any interest.
• Tenor Premium: An additional premium that is charged for loans with longer maturities to account for the increased risk over time.

What are the Key Differences Between Base Rate and MCLR?

1. Calculation Method:

• Base Rate: Primarily considers the average cost of funds, operating expenses, and a minimum profit margin.
• MCLR: Focuses on the marginal cost of funds, making it more responsive to changes in the RBI's policy rates. It also incorporates the tenor premium, which was absent in the base rate system.

2. Responding to changing policies:

• Base Rate: The base rate is less sensitive to immediate changes in policy rates, leading to slower transmission of rate cuts or hikes to borrowers.
• MCLR: When it comes to MCLR, it is more dynamic and adjusts more swiftly to policy rate changes, ensuring that borrowers benefit from rate reductions more promptly.

3. Transparency

• Base Rate: While it brought some level of transparency compared to previous systems, it still had limitations in reflecting the true cost of funds.
• MCLR: Offers greater transparency as it mandates banks to publish their MCLR for different tenors which lets the borrowers make informed decisions.

What is the Impact on Personal and Gold Loans?

The influence of MCLR and base rate on loans depends on the type of interest rate applied:

• Floating Interest Rate Loans: Loans with interest rates that fluctuate with market conditions are directly impacted by changes in MCLR. For instance, if the MCLR decreases, the interest rate on a personal loan with floating rate is likely to decrease, reducing the Equated Monthly Instalments (EMIs) for the borrower.
• Fixed Interest Rate Loans: These loans have a constant interest rate throughout their tenure and are generally unaffected by changes in MCLR or base rate. However, upon renewal or refinancing, the prevailing MCLR may influence the new interest rate.

It's important to keep in mind that while MCLR primarily affects loans with floating interest rates, some banks may offer personal loans linked to MCLR. Therefore, borrowers should clarify with their banks whether their personal loans or gold loans are tied to MCLR or are based on a fixed rate.

Moving from Base Rate to MCLR

With the introduction of MCLR, the RBI aimed to enhance the transmission of monetary policy rates to lending rates. Borrowers with loans linked to the base rate have the option to switch to MCLR-based rates. However, this decision should be made after considering factors such as the remaining loan tenure, potential savings from a reduced interest rate, and any charges associated with the switch.

Conclusion

Understanding the distinction between the Base Rate and the Marginal Cost of Funds Based Lending Rate (MCLR) is essential for borrowers aiming to make wise and informed decisions. The MCLR system offers a more transparent and responsive framework which ensures that changes in policy rates are effectively transmitted to borrowers.

Whether you're considering a personal loan, gold loan, or any other form of credit, being aware of these changes or setting benchmarks will help you assess how interest rates are calculated and how they may affect your repayment obligations.