Which is better – MCLR linked loan rates or RLLR linked loan rates?

As we all have seen in the past few months our Finance Ministry and RBI together have been in great action to bring the derailed economy on track. And for that, they are trying to take all the possible actions which are in demand as per the time and circumstances.

One of those actions is the “Repo Linked Lending Rates” concept which has been introduced by RBI in October 2019. It has been applauded by many economists and finance experts and has received many positive responses from layman also.

So, before that, we will try to understand some more concepts.

Marginal Cost of Lending Rate (MCLR) linked Loans

1. What is MCLR?

• The concept of fixing the interest rate on loans through Marginal Cost of Lending Rate by RBI on 1^st April 2016 replacing the Base rate structure regime.
• MCLR is an internal benchmarking rate fixed by the banks below which it cannot lend to the borrowers except in some cases allowed by RBI.

2. How is MCLR determined?

MCLR is determined considering 4 factors namely:

• Marginal Cost of Funds:
• MCLR methodology comprises of Marginal cost of borrowings and Return on Net worth appropriately weighed i.e.,

Marginal cost of funds = (Marginal cost of borrowings * 92% ) + (Return on net worth * 8% )

• The marginal cost of borrowing refers to the average rates at which deposits of similar maturity were raised in the specified period preceding the date of review, weighed by their outstanding balance in the bank’s books.
• The weight given to return on net worth is set equivalent to the 8% of risk-weighted assets prescribed as Tier I capital for the bank.
• Thus, the marginal cost of borrowings has a weightage of 92% while return on net worth has an 8% weightage in the marginal cost of funds.

• Tenor Premium:
  • The tenor of loans also plays a specific role in defining the MCLR. Higher the tenor of loan higher will be the premium.
  • As per the basic concept of finance, more risk more return. So, banks shift the burden of higher risk in the form of a higher premium on the borrower.

• Negative carry on CRR
  • Negative Carry means the cost of holding the investment exceeds the income earned while holding such investment.
  • So, the Negative carry on CRR means the money held as CRR by the banks cannot be utilized by the banks for the lending purpose to the borrowers.
  • It is basically an idle fund which the banks had to keep with RBI which doesn’t earn any income. And above that banks have to pay interest on such funds to the depositors.

• Operating Costs
  • One of the major costs which the banks need to consider before fixing the MCLR is their operational costs like the cost of raising funds, service charges, Type of borrowers to whom the money is lent, etc.

3. Reasons for introducing MCLR:

• RBI decided to shift from base rate to MCLR because the rates based on the marginal cost of funds are more sensitive to changes in the policy rates.
• This is very essential for the effective implementation of monetary policy. Prior to the MCLR system, different banks were following different methodologies for calculation of base-rate /minimum rate – that is either on the basis of the average cost of funds or marginal cost of funds or blended cost of funds.

Thus, MCLR aims

• To improve the transmission of policy rates into the lending rates of banks.
• To bring transparency in the methodology followed by banks for determining interest rates on advances.
• To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
• To enable banks to become more competitive and enhance their long-run value and contribution to economic growth.

Repo Linked Lending Rates (RLLR)

In October 2019, RBI came with an all-new set of reforms to boost the credit growth in the market with an aim that all the customers get the benefit of the rate cut by RBI immediately without waiting for the banks to takes a decision on the same. Let’s understand it in detail.

1. What is Repo Linked Lending Rate (RLLR)?

• As the name suggests, the lending rates are linked to Repo Rates fixed by the RBI.
• Repo Linked Lending Rate is linked to External benchmarks and RBI’s Repo rate is one of them.
• All the banks have their different RLLR and it gets revised each time RBI changes the Repo Rate.
• So, RBI has mandated all the banks to lend all the loans at RLLR from 1^st October 2019 onwards.

2. What is the difference between MCLR based loan and RLLR based loan?

• As we all know EMI consists of Principal & Interest
• In MCLR based loan the EMI is calculated by applying the interest rate on the outstanding loan amount. So, the EMI remains constant but the principal and interest rate keeps on changing during the whole tenure of the loan.
• But in RLLR based loan the whole principal gets spread over the entire loan tenure in equal amount and the EMI amount and interest amount keeps on changing.

3. Which is beneficial: MCLR linked loans or RLLR linked loans?

• As explained above in MCLR the EMI is constant and in RLLR linked loans the principal amount is constant.
• So, for clear view let us understand it with an example

• So, it can be clearly seen that even though the Principal, ROI, and tenure of the loan is same on both the types of loan, then also the RLLR linked loans is beneficial to the borrowers.

Conclusion:

• In RLLR linked loans the interest burden on customers is much less than MCLR linked loans.
• The benefit of the rate cut in Repo Rate by RBI will immediately be transferred to the customers without any delay.
• In RLLR linked loans, whenever RBI increases the Repo rate the interest rate will increase and whenever it will reduce the interest rate will reduce with the same increase or decrease.

Advice:

• RLLR linked loans will be beneficial for all the borrowers whether they are existing borrowers or new borrowers.
• So before applying for the loan the potential borrower should ask the bank about the tentative repayment schedule so that they can exactly know which option is beneficial for them.

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