What Is MCLR: Full Form, Meaning, and Impact

MCLR, or Marginal Cost of Funds Based Lending Rate, is a base rate of interest that help banks determine the minimum interest rate on various credit products such as personal loans and business loans. According to CRIF High Mark's annual report, lending habits in India indicate a growing preference for higher-value loans. In this blog, we delve deeper into a comprehensive understanding of MCLR and its implication on borrowers. Continue reading to know more!

MCLR: Full Form and Understanding

A rate that affects many borrowers in India, MCLR is an abbreviation for Marginal Cost of Funds Based Lending Rate. Simply put, it is the lowest interest rate at which banks or financial institutions can lend funds, except in certain cases sanctioned by the Reserve Bank of India.

MCLR was instituted by the apex bank in April 2016 to make policy rate changes transmit faster to borrowers. Unlike conventional approaches, MCLR focuses on the recent cost of funding. This is because it makes pricing more responsive to the current market environment. Let's explore why this change was needed, and the impact it had.

Why Was MCLR Introduced?

The MCLR replaced the decades-old base rate regime system. Prior to 2016, when the RBI would lower rates to boost economic growth, borrowers would receive the benefits much later. This was due to the slow transmission of monetary policy, resulting in some borrowers paying larger EMIs even after drastic rate cuts.

MCLR interest rate was introduced to tackle this problem and enhance transparency in loan pricing. MCLR mandates that banks determine a periodical reset, which in turn is based on the bank's marginal cost of funds. Plus, banks have to now clearly link their lending rates to their funding costs, enhancing transparency in their pricing mechanism for borrowers. Any change to the repo rate impacts banks' marginal costs more directly, leading to faster adjustments in the lending rate.

MCLR vs Base Rate: Key Differences

While banks rely on both MCLR and base rate to determine minimum lending rate, the former is more responsive to changes in the RBI rates.

The following comparison table highlights the key differences between MCLR and base rate.

Criteria MCLR (Marginal Cost of Funds-based Lending Rate) Base Rate Calculation Basis Uses the marginal cost of funds, which reflects current borrowing costs. Based on the average cost of funds. Monetary Policy Link Directly linked to the RBI’s monetary policy through the inclusion of the repo rate. No direct connection to the RBI’s policy rates. Pricing Approach Allows risk-based pricing using tenor premiums, different interest rates for different loan tenures. One-size-fits-all pricing, no scope for varying rates across loan durations. Review Frequency Reviewed monthly, enabling faster rate changes. Reviewed quarterly, resulting in slower transmission of policy changes. Market Responsiveness More responsive to current market conditions and policy shifts. Less responsive to real-time changes in the market or monetary policy.

Also Read: How to Choose the Right Personal Loan for Your Financial Needs

How do Banks Calculate MCLR?

The formula to calculate MCLR is as follows: MCOF + Negative Carry on CRR + Operating Cost + Tenor Premium

Here's an explanation of each of the main components:

• Marginal Cost of Funds (MCOF): The cost at which banks raise funds. Typically, it comprises interest paid on deposits and borrowings (around 92%) and Return on Net Worth, representing the cost of the bank’s capital (around 8%).

• Negative Carry on CRR: Banks must hold 4% of deposits with the Reserve Bank as Cash Reserve Ratio (CRR), which earns no interest. This negative carry is treated as a cost in the funds-based lending rate, as it affects the bank’s ability to earn from those reserves.

• Operational Costs: Covers operating costs like administrative expenses, employee salaries, branch upkeep, and tech systems involved in lending. These operational expenses are essential to deliver services and are distinct from service charges recovered from customers.

• Tenor Premium: A risk-based charge applied to longer-term loans. Higher tenors carry more credit risk, hence a tenor premium is applied. This is why longer loan tenures often attract higher loan interest rates compared to shorter loan durations.

Also Read: Secure a Loan Against Property Without CIBIL Scores: Your Comprehensive Guide

Types of MCLRs and their Applications

• Overnight MCLR: Best suited for very short-term loans or emergency credit needs.

• One-month and Three-month MCLR: Commonly used for working capital loans taken by businesses.

• Six-month MCLR: Typically applied to Personal Loans and SME credit lines.

• One-year MCLR: Most relevant for retail loans linked to the MCLR, especially MCLR linked Home Loans. It acts as the benchmark for many lending products offered to individual borrowers. For example, if the one-year MCLR is 8.5% and the bank's spread is 0.5%, the effective Home Loan interest rate becomes 9%. This rate remains fixed until the next reset date.

How MCLR Affects Loan EMIs

MCLR-based loans do not change with daily market rates. Instead, they follow a reset cycle determined by the bank at the time of loan sanction, typically every 6 or 12 months. On the reset date, the interest rate is revised based on the prevailing MCLR and the applicable spread. Until the next reset, both the rate and EMIs remain fixed, regardless of MCLR fluctuations in between.

To illustrate, if you've a 15-lakh Education Loan , the EMI may be reduced by Rs 1,000 per month after the annual reset if MCLR is cut by 0.5%. However, this exhibits opportunities as well as challenges. When the rates come down, you may have to wait for months to benefit from it. On the other hand, when the rates go up, you're shielded till the next reset.

Loans Not Covered Under MCLR

• Loans against Fixed Deposits are typically offered at lower interest rates since they’re secured by the deposit itself.

• Staff Loans are given to employees who receive loans at concessional interest rates, separate from standard MCLR-linked products.

• Loans under government schemes like Pradhan Mantri Jan Dhan Yojana have unique pricing structures and are not MCLR-based.

• Fixed-rate loans with a tenure of more than three years are exempt from MCLR regulations.

Practical Tips for Borrowers

• Check the spread over MCLR i.e. the additional percentage added over the MCLR rate, dependent on the applicant’s credit score, loan type, and bank policy. It directly affects the final interest rate.

• Understand the reset period; shorter resets help when rates fall, but may increase EMIs when rates rise.

• You can consider shifting loans taken before April 1, 2026 to the MLCR mode since it may offer better rates; it is recommended to approach your bank for the same.

• It is highly recommended to track their bank’s monthly MCLR updates to stay informed about potential EMI changes.

Benefits and Limitations of Marginal Cost of Funds Based Lending Rate

There are several benefits of MCLR rates although it comes with it's own limitations as well. They are as follows:

Benefits

• The MCLR reflects a more transparent and structured method for setting the minimum lending rate.

• Monthly MCLR reviews help commercial banks keep lending rates aligned with current market conditions.

• Its link to the RBI’s repo rate ensures that changes in the repo rate influence borrower interest rates faster than older systems and benefit borrowers.

Limitations

• Due to the reset period, changes in the repo-linked lending rate do not affect your EMIs immediately.

• Banks can decide the spread over MCLR, so loan interest rates can still vary depending on the spread and the lender's policies.

• Different loan tenures and reset cycles make it difficult to compare floating interest rates among lenders.

Overcoming MCLR Shortcomings: External Benchmarks

To overcome the shortcomings of MCLR, the RBI floated External Benchmark Linked Lending Rates (EBLR) in 2019, providing quicker transmission of rates. This means that loans can also be linked to the RBI's repo rate, an official benchmark interest rate, and a few other external benchmarks.

So, in addition to MCLR, financial institutions offer loans with the Repo Linked Lending Rate (RLLR), which is a type of EBLR. This provides the choice between rate certainty and rapid market sensitivity. As the lending rate scenario improves, newer benchmarking mechanisms offer alternatives to MCLR to borrowers looking for other rate attributes.

Also Read: High EMIs? Here's How to Reduce Your Personal Loan Burden

To Conclude

With Marginal Cost of Funds Based Lending, the loan pricing model has been made transparent and equitable to the Indian consumer, enabling them to make more informed decisions. Knowing MCLR enables borrowers to better navigate the lending space, regardless of whether they are salaried or self-employed.

At Poonawalla Fincorp, we believe in transparent lending with competitive interest rates on loans for various financial requirements. Apply now and experience affordable loans in just a few taps.

Frequently Asked Questions

What is the meaning of MCLR?

MCLR (Marginal Cost of Funds Based Lending Rate) is the minimum interest rate below which banks cannot lend, reflecting the cost of funds they incur. It determines loan pricing and is more responsive to market conditions than previous systems.

What is the purpose of the MCLR announced by the RBI?

The RBI introduced MCLR in 2016 to ensure faster transmission of policy rate changes to borrowers, promoting more transparent and responsive loan pricing by banks.

How does a higher MCLR impact loan interest rates and EMIs for borrowers?

A higher MCLR will lead to higher loan interest rates and higher EMIs for borrowers. Since MCLR directly affects the pricing of loans, when the rate increases, the overall cost of borrowing rises as well. This means borrowers will need to pay more in monthly instalments, making loans more expensive over time. It's important for borrowers to keep track of MCLR changes to anticipate how it will affect their loan repayments.

How is MCLR calculated by banks in India?

MCLR is calculated by banks in India based on specific formulas and guidelines provided by the Reserve Bank of India. It takes into account factors like the marginal cost of funds, the return on net worth, operating costs, and the tenor premium, ensuring loan pricing reflects current market conditions.

What happens when the MCLR changes?

When the MCLR changes, the interest rate on loans linked to it also changes. This directly affects the EMIs for borrowers, with increases in MCLR leading to higher loan costs, and decreases resulting in lower payments. Borrowers should monitor MCLR updates to anticipate any changes in their loan repayments.

Why did banks in India adopt MCLR as the standard for determining lending rates?

Banks in India adopted MCLR as the mandated standard for determining lending rates, replacing the earlier base rate system, to make loan pricing more transparent. The RBI introduced this shift to ensure faster transmission of it's policy rate changes in line with market conditions.

What is the difference between repo rate and MCLR rate?

The repo rate is the rate at which the Reserve Bank of India (RBI) lends money to commercial banks, while the MCLR rate is the minimum rate at which banks can lend to borrowers. MCLR was designed to replace the base rate regime and allow borrowers to benefit from rate cuts imposed by the RBI.

When do banks have to report their monthly MCLR?

Banks are mandated to disclose the complete range of MCLR rates by the last working day of each month. This helps borrowers stay informed about any upcoming changes in lending rates.