MCLR vs Repo Rate in Home Loan: Understanding the Difference

Did you know that even a subtle 0.25% change in the Reserve Bank of India's (RBI) repo rate can ripple through the entire economy, affecting everything from your home loan EMI to the interest on your business loan? When it comes to borrowing costs, understanding MCLR vs repo rate isn't just for economists—it's essential knowledge that can impact your financial well-being.

In this comprehensive guide, we'll demystify the nuanced differences between the Marginal Cost of Funds based Lending Rate (MCLR) and the repo rate, explore how they influence each other, and explain why the MCLR vs repo rate debate matters to you. Whether you're a prospective homeowner, an entrepreneur, or simply someone keen on making informed financial decisions, this article will equip you with the understanding you need.

What is MCLR?

MCLR stands for Marginal Cost of Funds Based Lending Rate. It is the minimum interest rate below which banks are not permitted to lend to borrowers. The Reserve Bank of India (RBI) introduced MCLR to ensure transparency, fairness, and efficiency in interest rate determination by banks. It takes into account various factors such as marginal cost of funds, operating costs, tenor premium, and a few other components. MCLR rates are revised periodically by banks based on changes in their funding costs and repo rate. As a result, while the repo rate affects the MCLR, they are not the same.

MCLR rates serve as benchmarks for different types of loans offered by banks, including home loans, personal loans, and business loans. When you take a loan with an MCLR-linked interest rate, your interest rate will be reset according to the bank's prevailing MCLR plus a spread (markup) decided by the bank.

What is Repo Rate?

Repo rate, on the other hand, is the rate at which the RBI lends money to commercial banks in the event of a shortage of funds. It acts as a tool for controlling inflation and managing liquidity in the market. When the RBI reduces the repo rate, borrowing becomes cheaper for commercial banks. Conversely, when the RBI increases the repo rate, borrowing becomes more expensive.

Commercial banks use the repo rate as a benchmark for determining their lending rates. The interest rate offered to borrowers is influenced by the repo rate along with other factors such as credit risk, cost of funds, and operational expenses. While MCLR is specific to individual banks, the repo rate is set by the RBI and affects all banks across the country.

Key Difference: MCLR vs Repo Rate

MCLR vs Repo Rate: How Each Affects Your Loan Interest Rates?

The MCLR has a direct impact on your loans if you have opted for an MCLR-linked interest rate. When the bank revises its MCLR, your loan interest rate will also be revised accordingly. If the MCLR decreases, your loan interest rate will decrease, resulting in lower Equated Monthly Instalments (EMIs). Conversely, if the MCLR increases, your loan interest rate will increase, leading to higher EMIs.

On the other hand, changes in the repo rate indirectly impact your loan interest rates. When the RBI reduces the repo rate, banks have access to cheaper funds, allowing them to offer loans at lower interest rates. Conversely, when the RBI increases the repo rate, banks' cost of funds increases, leading to higher loan interest rates.

Example:

Rahul has taken a home loan with an MCLR-linked interest rate from Bank A. At the time of taking the loan, Bank A's prevailing MCLR is 9% with a spread of 0.50%. Rahul's loan interest rate is therefore 9.50%.

After a year, Bank A decides to reduce their MCLR to 8.75%. As per the terms of Rahul's loan agreement, his interest rate will be reset based on the revised MCLR plus the spread. His new interest rate will be 9.25%. This means Rahul's EMIs will decrease, allowing him to save money each month.

How Do MCLR and Repo Rate Impact Home Loans?

While MCLR primarily affects loan borrowers, the impact of repo rate can be felt by both borrowers and savers alike. When banks reduce their lending rates in response to a decrease in the repo rate, it becomes cheaper for businesses and individuals to borrow. This can stimulate economic growth and promote investment.

For home loan applicants, a decrease in the repo rate may result in lower interest rates. Banks may adjust their deposit rates based on changes in the repo rate, which can affect the returns on your savings. However, it's important to note that savings account interest rates are also influenced by various other factors such as competition among banks and market conditions.