MCLR or External Benchmarks: Which is better for loans?

As part of a structural change to make banking more robust and transparent, the Reserve Bank of India (RBI) has directed banks to adopt an external benchmarking mechanism starting 1st October 2019. Amid the new regulations, all banks will now finalize interest rates on floating rate loans using an external benchmark index replacing the current Marginal Cost of Funds-based Lending (MCLR) system.

The need for external benchmarking

RBI first introduced a base rate system way back in 2010 where banks had to declare a lowest or base interest rate for loans. This was followed by adoption of MCLR system increasing transparency in fixing of interest rates.

Since the bank interest rate has many variables including bank’s spread, their current financial overview, deposits and non performing assets (NPAs) etc, both such internal benchmarks did little to facilitate any swift change in interest rates as per changes in RBI repo rate policy. There was no guarantee of an interest rate cut for borrowers even post RBI repo rate cut announcement.

Understanding external benchmarks and its benefits

Unlike MCLR which was internal system for each bank, RBI has offered banks the options to choose from 4 external benchmarking mechanisms: the RBI repo rate, the 91-day T-bill yield, the 182-day T-bill yield, or any other benchmark market interest rate as developed by the Financial Benchmarks India Pvt. Ltd.

To ensure complete transparency and standardization, banks are mandated to adopt a uniform external benchmark within a loan category. Banks are free to decide the spread over the external benchmark. However, the interest rate must be reset as per the external benchmark at least once every three months.

Being an external system, this means any policy rate cut decision will reach borrowers faster. The borrower will also know spread or profit margin for each bank over the fixed interest rate making loan comparisons easier and more transparent.

Linking external benchmarks to various loan types

RBI mandates banks to adopt external benchmarking system for interest rates for all floating rate loans, including retail loans and loans to MSMEs. Banks are, however, free to extend the same to other loans including fixed rate loans.

If you are seeking floating interest rate loans like home loan or a working capital loan, external benchmarking may be applicable. If, however, you are looking for a fixed interest rate loan like car loan or a personal loan, the new mechanism may or may not be applicable. Also, this external benchmark mechanism is applicable only for banks and not if you are seeking to borrow funds from a NBFC.

For an existing borrower, the change to the new external benchmarking system will only be facilitated post a request from your side. The switch can be made without any additional charges although you will need to pay administrative and legal costs as per your loan.

Which one should you go for—MCLR scheme or external benchmarking?

Despite adoption of external benchmarks, there is unlikely to be any steep decline in interest rates. While repo rates are currently close to their 15 year lows, any subsequent rise of repo rates in the future can impact your loan EMI. On the positive side, with faster resets, any change in repo rates will be transmitted much faster which is usually on the first day of the subsequent month.

Banks add spreads or their profit over the base rate to cover operating costs and risk premium. The adoption of external benchmarking will make the interest rates transparent. For example, if your bank is keeping a high spread on repo-linked loans, you can shift your loan to a different bank with a lower spread provided the difference in rates is substantial.

(By Nisary Mahesh, Founder, Hermoneytalks.com, and Managing Partner, Hubwords Media)

Source: Financial Express