Home loan rates: From what is MCLR to should you switch, all you need to know

Mumbai-based Vinayak Godbole (name changed on request) received a letter from his bank early this month. It wasn’t the regular statement, but a letter offering information about switching his home loan to the Marginal Cost of Funds Based Lending Rate (MCLR), a system of calculating interest rate for all retail loans that have a floating rate of interest.

“You have an option to switch from existing system of Floating Reference Rate to MCLR-1Y system, without changing the effective rate of interest. No switch fee would be applicable,” stated the letter.

The very terms, Floating Reference Rate and MCLR, preplexed Godbole. If you too have received a similar switch option to MCLR, then understand the steps you should take in the best interests of your home loan or other floating rate debt.

What is MCLR
In 2016 the Reserve Bank of India noted that while repo rates - rate at which RBI lends to banks - was altered, the same benefit wasn’t passed to the end customers, thus creating a lag effect in transmission of the central bank’s monetary goals. As a result, there was a big gap in the interest rate paid by old borrowers, whose loans were sanctioned between 2010 and 2011, as compared with those who took home loans later, between 2015 and 2016.

Since 2010, when the Base Rate was introduced, banks passed on the entire increase in repo rate to customers, but they have been reluctant to reduce Base Rates when RBI reduced policy rates.

Between calendar years 2010 and 2011 RBI, increased the repo rate on 10 instances, to the extent of 300 basis points (bps). Acting in tandem with the rate hikes, five major banks increased the Base rate to the tune of 300-275 bps.

But in 2012, when the repo rates were reduced by 50 bps on April 17, 2012, banks slashed base rates by 25-30 bps, in tranches. Some reduced the rates towards the fag end of the calendar year. In 2015, too, when RBI reduced repo rates on four occasions, to the tune of 125 bps, banks reduced rates marginally by 25-70 bps.

RBI had also remarked that a large proportion of bank loans continue to be linked to the Base Rate, despite raising concerns and asked banks to harmonise linking the Base Rate to the MCLR with effect from April 1, 2018.

Should you switch
Banks cannot arbitrarily decide to increase or decrease the MCLR. Hence, MCLR becomes a more transparent mechanism for consumers.

Vipul Patel, founder of an independent loan advisory firm, Mortgage World, said, “It’s not mandatory to move to MCLR. However, we recommend borrowers to move to MCLR as this pricing is in their favour. Ensure that the MCLR reset frequency is 12 months or lower.”

Wait to switch
However, moving borrowers from Base Rate to MCLR in the current scenario, where interest rates have been increasing after a pause of four-and-a-half years, is beneficial for banks. When asked why the bank had been proposing the switch option to borrowers now, when the rates are on an upswing, a leading bank declined to comment.

Experts suggest waiting for the interest rate tide to turn. “Interest rates are on the upward trend and borrowers can wait for a while before shifting to MCLR. This window of switching to MCLR would remain open even later, when the interest rate scenario is subdued. Overall, the benchmark rates are aligned to MCLR and the benefits would accrue to MCLR faster than other rate systems, when the rates are reducing,” suggested S Govindan, former general manager of Union Bank of India.

One can shift to MCLR when rates start tapering again. This is because even a 0.25% increase in interest rate to 8.75% from 8.5%, on a Rs 50 lakh home loan, has the potential to increase the interest burden by Rs 8.73 lakh. This is because the banks tend to increase the tenure of the loan when rates rise. So, if the tenure increases to 310 months from the original 300 month, then one would pay interest of Rs 79.51 lakh(@8.75%), instead of Rs 70.78 Lakh (@8.5%)

“Overall, in the long-term, rates will decline and home loan being a long-term product the borrower would stand to gain over the period of the loan,” Patel added.

Fixed rate offering
This switch apart, banks have also been moving consumers to fixed rate loans in the increasing rate scenario. But one must understand that foreclosure charges on a fixed-rate product could be steep. This could prove to be a stumbling block if you want to shift to a lender offering cheaper rates, going ahead.

Source: DNA Money