Interest rates, be it to individuals or institutions, play a crucial role in planning finances. Two distinct rates employed to calculate the interest for any loan are the base rate and the marginal cost of funds-based lending rate (MCLR). So let’s look at the rates at work and how they help keep borrowing costs low.
What is the base rate?
According to the Reserve Bank of India (RBI), commercial banks are required to implement a minimum lending rate that would be referred to as base rate, below which they may not lend to the borrowers. This rate is a reference point for loans and the bank calculates it based on the average cost of its funds, which includes profitability, operating costs, and the cost of holding in reserve.
Factors influencing the base rate
- The interest paid by banks on the deposits is reflected in the average cost of funds.
- Daily running costs, such as payroll, depreciation, and legal fees, comprise the operating cost of the firm.
- The cash reserve ratio, or CRR, is the amount banks must pay to the RBI to maintain the required amount of reserves.
- The banks are ensured to show profitability after paying for both funding and operating costs due to the profit margin.
What is MCLR?
The marginal cost of funds-based lending rate, implemented to make lending rates more dynamic and representative of the state of the economy, is the lowest interest rate at which banks are permitted to charge on loans. The base for MCLR calculations consists of operating costs, the bank’s incremental cost of funds, and a tenor premium, which offsets the risks of long-term loans.
What experts say about base rate and MCLR?
Ankit Mehra, Cofounder and CEO, GyanDhan said, “The base rate is the minimum lending rate set by banks before 2016, ensuring no loans were given below it, except for specific cases. However, the Marginal Cost of Funds-Based Lending Rate (MCLR), introduced in April 2016, is a more dynamic benchmark linked to the bank’s cost of funds.”
Manish Aggarwal, Director, Fundbook, expresses his opinion about base rate and MCLR, and tells which option people prefer mostly, “Base Rate offers stability since it doesn’t change often, but that means borrowers miss out when rates drop. On the other hand, MCLR adjusts quickly to RBI repo rate changes, making it more dynamic and often cheaper for borrowers. For most borrowers, MCLR is the smarter choice as it aligns better with market conditions and helps save money when rates fall.”
“As India’s vision for inclusive economic development gains momentum, systems like MCLR are proving to be vital in bridging financial disparities and ensuring that the benefits of economic growth touch all segments of society. By aligning credit access with real-time economic shifts, MCLR is not just a tool for efficient lending but also a catalyst for social and economic transformation,” Joydip Gupta, Head of APAC, Scienaptic sheds light on the significance of MCLR.
Should you switch from base rate to MCLR?
To attract larger benefits, the RBI asks the banks to let the base rate-linked loan borrowers opt for MCLR when policy rates are reduced. However, this choice would depend upon the terms of your loan and your current financial condition. You should discuss with a financial advisor how you may proceed and how to balance out the pros and cons.
In conclusion, understanding the difference between base rate and MCLR is very important in making sensible decisions to borrow. The MCLR is a dynamic system that reacts to the changing economy and, therefore, better reflects a bank’s funding cost. The base rate serves as a benchmark that does not change.
