Ahead of the Reserve Bank of India’s (RBI) bi-monthly monetary policy review later this week, the State Bank of India has increased the marginal cost of funds-based lending rate (MCLR) by 5 basis points, effective 1 October, across various tenures.

RBI has raised the benchmark repo rate by 50 bps in total in the past two policy meetings, and another hike is being widely expected in its 5 October announcement. 

Typically, home loans are pegged to one-year MCLR. This is the fourth time in calendar year 2018 that SBI has increased one-year MCLR, which has gone up from 7.95% at the beginning of 2018 to 8.50% now, an increase of 55 bps. One bps is one-hundredth of a percentage point.

While new borrowers will have to pay a higher interest rate on their home loans, existing home loan borrowers may continue paying the same rate until the reset clause kicks in. Every loan has a reset clause, which specifies the period after which the prevailing interest rate can be changed.

What is MCLR? 

Till 31 March 2016, all floating rate loans were benchmarked with base rate, which was the lowest rate at which a bank could lend. However, there were concerns that when the overall interest rates were going down, the reduction was not getting passed on to the consumers adequately. Hence, a new and more transparent system was brought in. 

From 1 April 2016, all new floating rate loans, like home and car loans, are linked to MCLR. This rate is based on four components—marginal cost of funds, negative carry on account of cash reserve ratio, operating costs and tenor premium.

MCLR is linked to actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up. When deposit rates go down, the MCLR also goes down subsequently. The way MCLR is calculated, it is more sensitive to RBI policy rate changes and hence transmission is faster.

MCLR is the minimum rate at which commercial banks can lend. Most banks charge a spread to most customers over MCLR, based on the credit and risk profile of the customer and the type of loan that the person is availing. To attract good customers, some banks have also started offering loans at MCLR to customers with a good credit score. 

Base rate vs MCLR 

If you have taken a loan before April 2016 from a bank, which would be a loan based on base rate, you have the option to move from base rate to MCLR. With effect from 1 October, SBI has also increased its base rate from 8.95% to 9%. 

Just like MCLR-based loans, base rate-based loans too charge a spread over the base rate. So while the base rate is higher than MCLR, you need to ascertain the effective rate after the switch in comparison to what you are paying at present. You will also need to take into account the conversion fee to move from base rate to MCLR. While it can be negotiated, banks usually charge 50 bps of the outstanding amount or a flat fee as conversion fee. 

If the difference in the interest rate on older base-rate based loan and the effective rate after switching to MCLR is significant, say over 25 bps, and you have many years of repayment ahead, you might want to make the switch. However, if the difference in the two effective rates is marginal or you have a short repayment time left, you might not want to switch.

If you are a new borrower, shop around to see which lender is offering the best interest rates. If you have a good credit score, you could negotiate and get a rate as low as MCLR itself, particularly for home loans.