Linking base rate to MCLR may not be good enough

Customers should still consider shifting to the best MCLR-linked home loan rate available

Home loan borrowers, who had taken loans before April 2016, can expect some relief from April 1. In the Statement on Developmental and Regulatory Policies issued along with the monetary policy statement on February 7, the Reserve Bank of India (RBI) said that it has decided to harmonise the methodology for determining benchmark rates by linking the base rate to the marginal cost of funds based lending rates (MCLR) with effect from April 1, 2018. At present, the average difference between the MCLR and base rate for banks is around 70 basis points.  

The RBI had introduced the MCLR regime on April 1, 2016 to overcome the limitations of the base rate. The primary issue with the base rate was that banks used it to either not cut their lending rates or to do so after a long lag in response to RBI's rate cuts. An internal committee of the RBI led by Janak Raj had found that both public and private sector banks manipulated base rate calculation, in a manner detrimental to customers’interests. 

After the introduction of the MCLR, the RBI had expected that most customers whose home loans were linked to the base rate would migrate to loans linked to the MCLR. But this did not happen and a considerable number of home loan customers, around 30 per cent, were still on the base rate. Hence, the RBI has now decided to harmonise the methodology for determining the base rate with the MCLR. According to Adhil Shetty, chief executive officer (CEO) and co-founder, Bankbazaar.com, “This ties the base rate scheme to a more responsive system of benchmarking interest rates and will enable a smoother transfer of policy rates.” 

What harmonisation means: During the press conference held on the day of the monetary policy, RBI deputy governor NS Vishwanathan emphasised that the central bank is thinking of ‘harmonisation and not equalisation of rates’. According to Naveen Kukreja, CEO and co-founder, Paisabazaar.com: “The language of the statement suggests that both the base rate and the MCLR will co-exist. However, the computation of the base rate will be linked to the MCLR.” Adds Shetty: “Currently it appears that once the base rate is linked to the MCLR, the former will vary in sync with the MCLR.” Complete clarity on how the new system will operate will emerge at the end of this week, once the RBI comes out with instructions.

What should you do: A more responsive system of benchmarking interest rates will mean that policy rate changes will reach borrowers on the base rate regime faster. According to experts, one of the following two scenarios is likely. One, the RBI may decide to bring base rate borrowers under the MCLR system. This would be welcome news for these customers. This transition would potentially close the gap between the base rate and the MCLR interest rates. It can result in significant savings for borrowers, especially those whose loans are less than five years old. Suppose that the principal due on a loan after four years is ~4.5 million for a 20-year loan. The initial rate of interest stood at 9.05 per cent. If it drops by 70 basis points to 8.35 per cent, the customer stands to save ~362,628 in interest cost over the remaining tenure of 16 years 

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However, if the RBI just stops at linking the base rate calculation with the MCLR, customers should first study the correlation between the two rates before deciding what to do next. While the base rate may become more responsive, customers on base rate linked loans could still be paying a higher rate. If the difference between their rate and their bank's MCLR-linked loan rate is considerable and they are only a few years into their loan tenure, they should consider paying the switching fee and shifting to the MCLR rate, depending on the saving they stand to make. If their bank doesn't permit this, they should consider transferring their loan to another bank. The final option is to continue on the base rate, especially for customers who are close to the end of their loan tenures. 

Lessons for the future: Investors on the base rate regime need to draw a lesson from what has happened. When rates were falling for the past couple of years, they did not take advantage of it by moving to a more responsive benchmark. Now, even if the base rate is linked to the MCLR and becomes more responsive, this will happen in a rising rate environment. While their benchmark may respond faster to RBI's rate changes in the future, it is more likely to move up rather than down. They should also bear in mind that rate changes for base rate customers can be passed on immediately while for those whose loans are linked to the one-year MCLR it happens only when the time for reset arrives. 

The RBI also  seems to be giving a quiet burial to the recommendations of the Janak Raj internal committee report, which had said that home loans should move to an external benchmark. Experts say that the adoption of such a transparent benchmark would be a true game changer.