In recent past, some of the readers of this blog posted queries on a switch from Base Rate to MCLR (Marginal Cost of Funds based Lending Rate). The queries were similar in nature i.e. credit/loan manager of the bank suggested them to shift from base rate to MCLR. These are the borrowers who availed home loan before 1st April 2016 linked to base rate. The home loans availed on or after 1st April 2016 are by default linked to the MCLR. Therefore, this post is relevant only for borrowers whose home loan is linked to the Base Rate of the bank.
It is observed that the loan manager of the banks including PSU banks is misleading the borrowers whose home loan is linked to the base rate. In 1st stage, the bank employees are suggesting borrowers shift from base rate to MCLR through comparison. I suggested the readers of the blog to counter question how MCLR is beneficial compared to base rate? Trust me not even a single bank employee was able to explain or justify. The common answer was that MCLR is less than the Base Rate of the bank but the big question is whether the bank is passing the benefit to the borrower? Let me answer in the following section.
NO Immediate Financial Benefit to Switch from Base Rate to MCLR
Let me share the example of one of the readers of this blog Mr. A. Last year, he availed home loan from PSU Bank at 9.55%. The base rate of the bank was 9.30% and there was a markup of 0.25% on base rate. Now the bank is insisting Mr. A shift from Base Rate to MCLR. The sales pitch for this switch is to take advantage of low Marginal Cost of Funds based Lending Rate. The MCLR of the bank is 9.10%. Therefore, Mr. A is under impression that post switch, his home loan interest rate will decrease from 9.55% to 9.35%. In other words, the difference of 0.20% between Base Rate and MCLR will be passed to Mr. A.
Unfortunately, it is NOT CORRECT Understanding. To clarify, the home loan interest rate of Mr. A will remain the same after a switch to Marginal Cost of Funds based Lending Rate. Assuming Mr. A decides to switch. His markup or spread will increase to 0.45% from 0.25%. Therefore, home loan interest rate will be MCLR + Markup i.e. 9.10% + 0.45% i.e. 9.55%. To summarize, there is NO Immediate financial benefit to a borrower if he/she decide to switch from Base Rate to MCLR.
Why Banks Are Forcing Existing Home Loan Borrowers To Switch to MCLR?
If the bank is not able to trap the borrower by comparing MCLR and Base rate then the next strategy is to create a fear. In one of the instance, a bank employee told the reader of this blog that if she does not switch to MCLR now then in near future all the borrowers on base rate will be migrated to Marginal Cost of Funds based Lending Rate by default. To clarify, the bank is misleading the borrowers. The borrowers on base rate may continue base rate as benchmark rate until the end of the home loan period. Bank cannot forcefully migrate the borrowers from base rate to Marginal Cost of Funds based Lending Rate. In other words, the bank is forcing borrowers to migrate. You must be wondering WHY? let’s check out.
1. Anticipation of increase in Interest Rate:
As i shared in my earlier posts on Marginal Cost of Funds based Lending Rate that MCLR will be more beneficial during decreasing interest rate. On the other hand, the base rate is financial beneficial during increasing interest rate. This understanding is from a borrower’s perspective.
From bank’s perspective, the reverse theory is beneficial. The reason being, interest rates will increase faster under MCLR compared to the base rate. Therefore, higher interest rates mean high profitability/margins for the banks.
The experts are of the opinion that interest rates have bottomed out. The interest rates and inflation move in tandem with each other. In recent past, the inflation started increasing, therefore, RBI will not be able to hold the low-interest rates if inflation moves beyond 6% i.e. upper range set by the RBI. Therefore, in anticipation of an increase in interest rates, banks are forcing borrowers to switch to MCLR linked home loan. Whereas it is more beneficial for the borrower to stick to base rate if interest rates start increasing.
2. MCLR linked Home Loan is a sort of Fixed Interest Rate Home Loan:
In my post, New Lending Rate – 5 Loopholes RBI should have fixed i shared that under MCLR reset date for the interest rate is max 1 year. In fact, one of the largest home loan providers link the home loan interest rate to 1 Year MCLR, therefore, interest rate reset date is One year. What it implies is that the interest rates will not be changed for one year. In short, the home loan becomes fixed interest rate home loan with reset period of one year. Normally, the fixed interest rate home loan reset period is 3 years.
Fixed interest home loan is always beneficial for banks as it provides stability to the loan portfolio of the bank. Now you must be wondering this is good for the borrower, if the interest rate increase as i shared in point no 1. I agree it is beneficial for borrower but only in short term (max up to 1 year). Hypothetically, if today my interest rate is 9.5% under base rate. I migrate to MCLR at the same interest rate. During next 1 year, interest rates will increase to 10.25% under MCLR but i will be paying only 9.5%. So far so good :)
Suddenly after 1 year, my interest rate will increase to 10.25%. Whereas under base rate, the interest rate might be somewhere around 9.85% as per my estimate. Let say, interest rates remain stable for next 2 years. Now to find out which option is more beneficial. You can calculate savings of 0.75% for one year under MCLR and savings of 0.40% for 2 years minus 0.35% extra interest for 1st year with 3 months interest reset period.
As per my calculations, home loans linked to base rate will be more beneficial. Though it is subjective and may vary from case to case basis. Over a long term, the base rate will be definitely financial beneficial in case interest rates are increasing. On the contrary, MCLR is beneficial during softening interest rate cycle.
In few cases, banks told borrowers that they can switch back to Base rate from MCLR in future. Just to clarify, it is not correct. The migration from base rate to MCLR is irreversible. Due to low MCLR compared to base rate the borrower think that bank is doing a favor to him/her. In my opinion, it is otherwise :).
Words of Wisdom:
Any switch from base rate to MCLR will have a financial implication for the borrower. Therefore, it is advisable to take this decision only after proper research and financial calculations. Just based on the suggestion of a loan manager or credit manager you should not decide. You may question the bank to share the pros and cons of this switch. If the bank is not able to answer then it is visible that bank employee is bluffing around and you may continue with Base Rate.
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