MCLR (Marginal Cost of Funds based Lending Rate)

The Marginal Cost of Funds Based Lending Rate (MCLR) is the internal benchmark set by banks to determine minimum lending rates, as mandated by the Reserve Bank of India. Introduced in April 2016, MCLR replaced the older base rate system, aiming to make interest rate transmission more transparent and market-linked. 

This article will provide an overview of MCLR, including its calculation, implementation, impact on loans, benefits, limitations, and key differences from the earlier base rate system.

What is MCLR?

The Marginal Cost of funds-based Lending Rate (MCLR) is the minimum lending rate below which a bank is not permitted to lend. MCLR replaced the earlier base rate system for determining the lending rates for commercial banks.

RBI implemented MCLR on 1 April 2016 to determine rates of interests for loans. It is an internal reference rate for banks to determine the interest they can levy on loans. For this, they take into account the additional or incremental cost of arranging an additional rupee for a prospective buyer.

The Outcome of MCLR Implementation

After the implementation of MCLR, the interest rates are determined as per the relative risk factor of individual customers. Previously, when RBI reduced the repo rate, banks took a long time to reflect it in the lending rates for the borrowers.

Under the MCLR regime, banks must adjust their interest rates as soon as the repo rate changes. The implementation aims at improving the openness in the structure followed by the banks to calculate the interest rate on advances.

It also ensures the prospect of bank credits at the interest that is true to the consumers as well as the banks.

How MCLR is Calculated

MCLR is calculated based on the loan tenor, i.e., the amount of time a borrower has to repay the loan. This tenor-linked benchmark is internal in nature. The bank determines the actual lending rates by adding the elements spread to this tool.

The banks, then, publish their MCLR after careful inspection. The same process applies for loans of different maturities, be it monthly or as per a pre-announced cycle.

The four main elements of MCLR are made up of the following:

• Tenor premium
  
  The cost of lending varies from the period of the loan. The higher the duration of the loan, the higher will be the risk. In order to cover the risk, the bank will shift the load to the borrowers by charging an amount in the form of a premium. This premium is known as the Tenure Premium.
   
• The marginal cost of funds
  
  The marginal cost of funds is the average rate at which the deposits with similar maturities were raised during a specific period before the review date. This cost will reflect in the bank’s books by their outstanding balance. The marginal cost of funds has several components like the Return on Net Worth and the Marginal Cost of Borrowings. Marginal Cost of Borrowings takes up 92% while the Return on Net Worth accounts for 8%. This 8% is equivalent to the risk of weighted assets as denoted by the Tier I capital for banks.
   
• Operating Cost
  
  Operational expenses include the cost of raising funds, barring the costs recovered separately through service charges. It is, therefore, connected to providing the loan product as such.
   
• Negative carry on account of CRR
  
  Negative carry on the CRR (Cash Reserve Ratio) takes place when the return on the CRR balance is zero. Negative carry arises when the actual return is less than the cost of the funds. This will impact the mandatory Statutory Liquidity Ratio Balance (SLR) reserve every commercial bank must maintain. It is accounted negatively as the bank cannot utilise the funds to earn any income nor gain interest.

Types of MCLR Rates

Banks publish different types of MCLR for different tenures:

• Overnight MCLR – For very short-term loans, usually one day.
• 1-Month MCLR – Applied to ultra-short-term credit.
• 3-Month MCLR – Commonly used for short-term personal or working capital loans.
• 6-Month MCLR – Often tied to personal or SME loans with medium tenures.
• 1-Year MCLR – The most commonly used benchmark for retail loans like home loans.
• 2-Year and 3-Year MCLR – Less frequently used, but applicable for longer loan durations.

Banks reset your loan interest rate based on the MCLR tenure it’s linked to (e.g., if your loan is linked to the 1-year MCLR, the rate will reset annually).

Difference Between MCLR and Base Rate

Impact of MCLR on Loans

MCLR directly affects the interest you pay on floating-rate loans. When a bank revises its MCLR (due to changes in repo rate, CRR, or funding costs), your loan EMI can either increase or decrease after the next reset period.

For example, if your loan is linked to the 1-year MCLR and the bank reduces the rate, your EMI will only reflect this cut after the annual reset date, not immediately. This makes MCLR less responsive than repo-linked lending rates (RLLR), but still better than the older base rate system.

Benefits of MCLR

• Transparent Pricing: Based on clearly defined components like repo rate, operating cost, and CRR.
• Predictability: Loan resets are periodic and defined, which helps plan EMIs.
• Cost Efficiency: Tends to offer better rates than older systems like the base rate, especially when interest rates are falling.
• Link to RBI Signals: More responsive to monetary policy than base rate (though less than RLLR).

Limitations of MCLR

• Delayed Transmission: Rate changes don’t reflect immediately in your EMI—they kick in only after the reset period.
• Still Partially Administered: While more transparent than the base rate, it still gives banks some leeway in pricing loans.
• Frequent Reset Clauses Vary: Some banks reset every six months, others annually, which may delay rate benefits.
• RLLR Has Overtaken It: For many borrowers, repo-linked loans now offer more transparent and faster transmission of rate cuts than MCLR.

Deadlines to disclose monthly MCLR Rates

Banks have the liberty to make all loan categories available at fixed or floating interest rates. Additionally, banks need to follow specific deadlines to disclose the MCLR or the internal benchmark. These could be one month, overnight MCLR, three months, one year, or any other maturity as the bank deems fit.                                               

The lending rate cannot be below the MCLR for any loan maturities. However, there are other loans that are not linked to MCLR. These include loans against customers’ deposit, loans to the bank’s employees, special loan schemes by the Government of India (Jan Dhan Yojana), fixed-rate loans with tenures above three years.