What is MCLR and how does it work?

MCLR stands for Marginal Cost of Funds based Lending Rate. It is the internal benchmark rate used by banks in India to determine the interest rate on floating rate loans, including home loans, personal loans, and business loans. MCLR replaced the earlier base rate system in 2016 as per the guidelines of the Reserve Bank of India (RBI).

Here's how MCLR works:

1. Components of MCLR: MCLR comprises four components:
a. Marginal Cost of Funds: It includes the bank's cost of borrowing from various sources such as deposits, borrowings from other banks, and market instruments.
b. Operating Costs: These are the operational expenses incurred by the bank, including administrative costs, salaries, and overheads.
c. Tenor Premium: This factor accounts for the difference in costs based on the loan's tenor. Longer tenors generally have a higher tenor premium.
d. Marginal Cost of Borrowing: This factor reflects the proportion of the bank's incremental deposit and borrowing costs.

2. Reset Period: Banks are required to review and publish their MCLR rates at least once a month. The reset period is the time interval after which the interest rate on the loan will be revised based on the prevailing MCLR. The reset period can vary from one bank to another but is typically set at one year or shorter durations like three months or six months.

3. Spread: The bank adds a spread or markup to the MCLR to determine the final interest rate on the loan. The spread is determined by various factors such as the creditworthiness of the borrower, the type of loan, and market conditions. The spread remains constant for the loan's tenure, while the MCLR can change during the reset period.

4. Interest Rate Calculation: The interest rate on a loan linked to MCLR is calculated by adding the applicable spread to the prevailing MCLR rate. For example, if the MCLR is 8% and the spread is 2%, the final interest rate on the loan will be 10%.

5. Impact of MCLR Changes: When the MCLR changes during the reset period, the interest rate on the loan will also change accordingly. If the MCLR decreases, the borrower may benefit from a lower interest rate and reduced EMIs. Conversely, if the MCLR increases, the borrower may experience an increase in the interest rate and higher EMIs.

It's important to note that the RBI has introduced external benchmarks for certain types of loans, such as loans to small businesses and personal loans. These loans are linked to benchmark rates like the repo rate or the treasury bill rate, rather than the MCLR.

Overall, MCLR is an important factor in determining the interest rate on floating rate loans in India, and borrowers should be aware of the MCLR mechanism when applying for such loans.