The Reserve Bank of India, or RBI, will link the base rate for loans given by banks to the MCLR, starting April 1, 2018. Bhavik Mehta, director of FinREQ gets into the implications of this move.
The Base Rate is the lowest rate that a bank would lend to its best customers, and there won’t be any lending below that floor rate. This was put into practice in 2010 to avoid banks making the retail borrowers subsidise the rich corporate clients. Unfortunately, many banks manipulated that rate and the central bank felt that monetary policy transmission was not happening to the full extent possible.
There had been a lot of complaints that whenever the RBI reduced interest rates, banks took a long time to pass on the benefit to borrowers. Often, the benefit was passed on only partially i.e. banks did not reduce their lending rates by as much as the RBI cut the benchmark rates. Under the base rate regime, banks were either reluctant to cut their lending rates (post RBI repo rate cuts) or did so with a time lag.
This paved the way for a new method of bank lending. The marginal cost of funds based lending rate, or MCLR, was put in place for all loans, including home loans, given after April 1, 2016. This was introduced to tackle the problems of the Base Rate regime.
With the introduction of the MCLR system, it was expected that the existing Base Rate linked loans and other credit exposures would also migrate to MCLR system. However, this has not happened as banks are allowed to offer multiple lending rates linked to the tenor of the loan and each rate was fixed rate for fixed period. It has been observed that a large proportion of bank loans continue to be linked to the Base Rate despite the RBI highlighting this concern in earlier monetary policy statements.
Since MCLR is more sensitive to policy rate signals, it has been now decided by the RBI, in a recent circular, to harmonize the methodology of determining benchmark rates by linking the Base Rate to the MCLR with effect from April 1, 2018 from the new financial year.
Prima facie it appears that once base rate is linked to MCLR, the former (Base Rate) will automatically increase or decrease in tandem with the latter without any specific action required for adjustment. This may benefit the existing borrowers whose loans are still linked to the base rate.
Let’s assume a scenario.
- Home loan tenure: 30 years
- Loan tenure completed: 5 years
- Balance tenure of loan: 25 years.
Due to reduction in Base Rate, which will now be automatically linked to MCLR, the customer may benefit by 1-2% in ROI for the next 25 years, which can be substantial savings for the customer. It will definitely help the customer in reducing the equated monthly instalment, or EMI, every month by at least 10-30%. In the event of the customer choosing to keep the EMI same, the total balance loan tenure can be reduced by at least 20-30%. i.e. 25 years can now be reduced to 16-20 years depending on the facts of case.
Home loan borrowers would be in a position to save a lot of cash every month. This money will increase their savings which can be invested in other assets. In my view, this announcement will bring in more transparency in ROI/ pricing calculations of most of the banks.
