The Reserve Bank of India (RBI), introduced the Base Rate System in July of 2010 to ensure that Banks and NBFCs could lend credit to customers only above a certain threshold. However, due to some loopholes in the system, the objective of ensuring the effective transmission of a change in interest rates to customers could not be achieved. In a bid to bring about the required level of efficiency in the system, the RBI replaced it with MCLR, or Marginal Cost of Funds based Lending Rate, in April 2016.
Before we move on to understand the impact of MCLR on Home Loan Repayment, let us first take a quick look at what is MCLR.
As the name suggests, MCLR is the standard lending rate at which banks and other lending institutions ought to lend money to borrowers. MCLR is directly linked to actual deposit rates, and requires each bank and NBFC to submit as many as five rates to the RBI, including that for –
The calculation of MCLR primarily involves the following components:
To put it in the simplest of words, Marginal Cost of Funds refers to the cost that a bank will incur for offering one additional loan, considering that cost of funds for the bank remains unchanged.
Marginal cost of funds = (92% x Marginal cost of borrowings) + (8% x Return on net worth)
Also known as CRR, this ratio denotes minimum fragment of the total customer deposits that every bank must keep deposited with the Reserve Bank of India, at all times. Since this amount cannot be actively utilised by the bank, either for generating revenue or for the purpose of investment, it is often referred to as a negative carry.
It refers to the direct proportion of the length of the loan to the amount of premium that must be paid, i.e., the premium must be uniform for all types of the loan if the residual tenure is same.
These include the cost of funds as well as the cost incurred by the bank to provide a loan to the borrower.
Taking into account all these components,
1 Year MCLR = Interest rate offered by the bank on 1-year term deposit + CRR + Tenure Premium + Operating Costs
To begin with, let us make it clear that MCLR has no impact, whatsoever, on a fixed interest home loan. This system is linked to floating rate home loans only.
If you are new to the concept of floating interest rate, let us quickly break it down for you. As the name suggests, floating rates are those which vary with the fluctuations in the prevailing market rates. Simply put, floating rates usually comprise of two elements – a base rate which is constant, and a floating component which is variable.
Consequently, in case of floating rate Home Loans, the EMI will comprise of the principal component and the base rate, both of which remain fixed, along with a floating element which may exhibit fluctuations.
In this scenario, your home loan interest rates will largely depend on the reset period that your bank chooses – Six-Month MCLR or One-Year MCLR. So, whether you benefit from the change in the bank rate or not will be evident after the end of the reset period.
You must know here that the banks offer lower interest rates to customers opting for floating rate interest, as compared to those procuring fixed rate Home Loans, thereby putting a customer of the floating rate at an advantage.
That being said, you must understand that the rates may not remain low for a long stretch of time, and the effect will get reversed.
At such times, an ideal strategy would be to increase the Home Loan EMI thereby effectively reducing the Home Loan repayment period. However, it is best to initially opt for a longer repayment tenure and then as and when your finances allow make prepayments along the way.
You can even opt for accelerated repayment if you wish to bring more structure to your finances since this alternative is also free of any penalty.
Just in case you already have a Home Loan, and you wish to pay it off at the earliest possible, you can start by Opting for a Home Loan Balance Transfer.
Of course, before you do so, you must weigh the benefits of the same, against the time, effort and money (processing fee and other charges), that you will need to invest in doing so.
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