Marginal Cost-Based Lending Rate (MCLR) – How Do Banks Fix the Interest Rate?

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The Reserve Bank of India (RBI) introduced the concept of MCLR with effect from April 01, 2016. Before that, the banks were followed by the Base Rate methodology from July 2010. MCLR (Marginal Cost of Funds based Lending Rate) describes the method by which the minimum interest rate for loans is determined by a bank – on the basis of marginal cost, the additional cost or incremental cost of arranging one more rupee to the intended borrower. MCLR replaced the earlier base rate system to decide the lending rates for commercial banks. It is the minimum rate below which no bank can lend to its customers, except for some rare cases. MCLR can also be referred to as the internal benchmark rate or the reference rate for a bank.

The Marginal Cost of Funds based Lending Rate is closely linked with the repo rate and fund costs of the banks. Thus, if there is a change in the repo rate, it will have an impact on your home loan’s floating rate of interest. If a bank lowers the marginal cost of funds based on the lending rate, the floating rate of interest associated with your home loans also gets lower. However, this will not affect your equated monthly installments, but the tenure of the loan will get impacted.

Why is the MCLR Concept Preferred?

RBI moved to the MCLR concept because the MCLR is sensitive to the changes in the policy rates. This is quite essential for the implementation of the Monetary Policy. The primary objectives of introducing MCLR are as follows:

  • Simplify and improve the transmission of policy rates into the lending rates of the banks
  • Transparency in the methods that the banks follow for determining the rate of interest on loans
  • Make sure the availability of bank credit at rates fair to both the banks and the borrowers
  • Bring in more competition among the banks and amplify their contribution to the economic growth of the country

MCLR – The Computation

The amount of time left for the repayment of the loan is the tenure and the MCLR is a tenure-linked internal benchmark. It is not the actual lending rate. Moreover, the banks add their spread over the MCLR rate. This explains why you have the rate structure as MCLR + 1% or MCLR + 2%. The banks have to review the MCLR and produce them every month on a pre-announced day.

The MCLR consists of the following factors-

  1. Marginal Cost of Funds:

The marginal cost of funds is made up of the Marginal cost of borrowings and returns on the net worth’s, appropriately weighed.

Marginal cost of fund = (92% x Marginal cost of borrowing) + (8% x Return on net worth)

According to this calculation, the marginal cost of borrowings weights 92% while the return on net worth has an 8% weight in the marginal cost of funds. Here, the weight given to return on net worth is set equivalent to the risk-weighted assets prescribed as Tier capital for the bank. The marginal cost of borrowings refers to the average rates that were raised in the specified period ahead of the date of the review.


  1. Negative Carry on Account of Cash Reserve Ratio (CRR):

Banks do not get any interest on the mandatory deposits they make with the Reserve Bank of India as CRR. When the return on the CRR balance is zero you get a Negative carry on the CRR (Cash Reserve Ratio)

  1. Operating Cost:

Costs that banks incur on providing various loan products, not considering the costs covered by way of service charges.

  1. Tenure Premium:

It is uniform for all types of loans for a given residual tenure. The tenure premium is not borrower specific or loan category-specific.

The bank has to publish the MCLR for the following maturities:

  • Overnight MCLR
  • One-month MCLR
  • Three-month MCLR
  • Six-month MCLR
  • One year MCLR
  • MCLR for other tenures that banks deem fit

Actual Lending Rate

Banks add their spread to the MCLR and fix their rate of interest.

MCLR – Loans Excluded Under the Concept

  • Fixed-rate interest loans above 3 years
  • The government of India-formulated special loan schemes
  • Loans sanctioned to depositors against their fixed deposits
  • Advances to bank’s employees

All of this concludes that MCLR depends on the performance of the bank under all parameters. Banks will not be able to mobilize deposits at an extraordinary rate of interest as it can affect their MCLR adversely.