What a hike in MCLR means for borrowers: Who gets impacted and who doesn't

Marginal Cost of Fund based Lending Rate refers to the minimum interest rate a bank must charge for lending. The bank cannot grant any loan below that rate, except in certain cases permitted by RBI

Leading private sector lender, HDFC Bank has hiked benchmark marginal cost of funds-based lending rates (MCLR) by 5 basis points to 15 basis points with effect from 7 June. The lending rates have been raised from tenures starting overnight to six months, which means those who have home loans, personal and vehical loans tied to MCLR will get impacted.

What is MCLR

The Marginal Cost of Fund based Lending Rate refers to the minimum interest rate a bank must charge for lending. The bank cannot grant any loan below that rate, except in certain cases permitted by the Reserve Bank of India (RBI).

It is determined by various factors, including the bank’s own cost of funds and the repo rate set by the RBI. The repo rate is the rate at which the central bank lends money to commercial banks, and changes in the repo rate can have an impact on the cost of funds for banks.

When the central bank pauses or keeps the repo rate unchanged, it means there is no immediate change in the cost of funds for banks. However, banks consider multiple factors when determining their lending rates, including their own cost of funds, operating expenses, credit risk, and profitability targets. The repo rate is just one component that influences their cost of funds. Other factors such as market conditions, liquidity, and credit demand also play a role. While a pause in the repo rate may indicate stability in the economy, banks may still choose to increase their MCLR for various reasons. 

The MCLR now serves as a benchmark and was introduced to counter the base rate system. It has been in effect since April 1, 2016, for all the categories of domestic rupee loans. Simply put, starting from April 2016, interest rates for every single loan, irrespective of the category, will be governed by the MCLR," said Adhil Shetty, CEO of BankBazaar. 

MCLR is an internally produced benchmark by banks. It is set for various tenors ranging between overnight and three years. Banks link their deposit and loan rates to various MCLR tenors. A bank benchmarks its home and auto loan rates to its one-year MCLR.   For example, let’s say a bank has a one-year MCLR of 7.10  per cent over which it applies a mark-up of 35 basis points, which gives us a retail rate of 7.45 per cent

 If the cost of funds goes up, the MCLR increases, and the loans linked to any MCLR tenor get more expensive. Similarly, if the MCLR comes down, your loans get cheaper.  

What is the difference between MCLR and ELBR 

External benchmark-linked lending rate (EBLR) is a system parallel to the MCLR regime, in which banks peg the lending rate to a benchmark like repo rate. Hence, if the repo rate is hiked, it could lead to a consequent increase in EBLR as well, making loans costlier. Hence, EBLR is the new interest structure and the home loans and interest rate is linked to the External Benchmark. This method is introduced to reduce or increase the floating interest rate of every bank.

Since 2019, all banks have to link their retail floating rate to an external benchmark, and in case of most banks that is the repo rate. Unlike earlier benchmarks-MCLR and the base rate, the external benchmark lending rate ensures better transmission of policy rate changes. So, in case of a repo rate cut, banks have to pass the benefit to the borrower. Similarly, in case of a repo rate hike, borrowers will have to bear the burden of the hike. 

"Bank loans issued between April 1, 2016, and October 2019 are all linked to MCLR. Home loans issued after that date are linked to externally produced benchmarks such as the repo rate. Borrowers have the option of refinancing their MCLR-linked loans to repo-linked loans which are known to be more transparently priced and better transmitters of policy rate cuts," said Shetty. 

For instance,  from May 2022 to March 2023, the overall interest rate hikes was only 1.35% on most old home loans based on the 1-year MCLR  regime. But the new home loan borrowers, who took their loans under the external benchmark-based lending rates (EBLR) regime — which is the only option now for floating rate home loan borrowers, saw their home loan rates rise as much as the repo rate hike of 2.5%.

What is the difference in rate transmission between the two?

The latest spikes in MCLR at HDFC Bank indicate that deposit and loan rates are poised to rise. For MCLR-linked loan takers, the rate reset might happen as indicated in their loan agreement. Typically MCLR-linked home loans have rate resets once every six or twelve months, said Shetty.

How do these rates impact my home loans? 
Home loans are offered at a Benchmark + Spread. The benchmark keeps changing. Spread will typically remain constant during your loan tenure. The spread is calculated based on the borrower's credit score, income source, and loan size. 

Who gets the lowest spread rate?

Borrowers with a high CreditSscore and stable income are most likely to get the lowest spread rate, which remains constant throughout their loan tenure. So, while the rate may fluctuate, the spread rate remains unchanged, said Adhil Shetty of BankBazaar.
 

"You have taken a loan at the lowest spread rate of 1.90. Now, if the repo rate starts falling and stops at its lowest, of 4%, your interest rate will only be 5.90. Compare this with someone who has also taken a home loan at a spread rate of 2.65%. Their approximate interest rate will be 6.65%. Thus, a lower spread can help you rake in significant savings on your home loan EMIs," explained BankBazaar.

Who gets impacted

For HDFC Bank loan borrowers  the latest hike in MCLR rates will impact floating rate borrowers of personal loans and vehicle loans, which fluctuate with the change in the MCLR.

" The borrowers who are most likely to be affected by the rise in loan interest rates are those who have floating-rate loans. Such borrowers will see their monthly EMIs increase as the interest rate on their loan rises. Borrowers with fixed-rate loans will not be affected by the rise in MCLR," said Shetty.

After the latest hike, the HDFC Bank’s overnight MCLR will be 7.95 per cent. A one-month MCLR has witnessed a 10 basis point hike and is now set at 8.20% compared to the previous 8.10%.

The three-month MCLR has been increased by 10 basis points to 8.50 per cent , up from the earlier rate of 8.40 per cent.

The six-month MCLR has increased only 5 basis points, resulting in a new rate of 8.85 per cent compared to the previous rate of 8.80 per cent

HDFC Bank's current 1-year MCLR stands at 9.05 per cent , while the 2-year and 3-year MCLR rates are reported as 9.10 per cent and 9.20 per cent respectively.

Point to note: Ever since external benchmark lending rates and repo-rate-linked lending rates became applicable, not all term loans are linked to MCLR. So the hike in MCLR will not be faced in every loan category or by every borrower at HDFC Bank. It will only impact those who still have their loans linked to the MCLR.

When can you switch? 

If you are a new borrower, you don’t have any choice since your loan will be linked to an external benchmark. However, if you are an existing borrower and your loan is linked to MCLR or base rate, you will get an option to switch to external benchmark.

As per the RBI circular, if your loan is a floating rate loan and has no prepayment penalty, you will get an option to switch to the external benchmark by requesting your bank.

But do remember that once you switch from base rate or MCLR to the external benchmark, you cannot switch back to the old regime. 

Is there a way to save on the EMIs?

 In case of high interest rate on loans, you may be able to save money by refinancing your loan with a fixed-rate loan. However, it is crucial to compare interest rates and additional fees/charges before you opt for refinance, cautions Shetty.

Similarly, if you can afford to make extra payments on your loan or if you pre-pay 5% of the loan balance once a year, you can significantly reduce the amount of interest you pay over the life of your loan.