The merger of HDFC Ltd with HDFC Bank has heralded a significant shift in lending methodology for existing home loan borrowers. Consequently, the banks have started transitioning borrowers from the existing MCLR (Marginal Cost of Lending Rate) to ELBR (External Benchmark Lending Rate). This shift is vital for borrowers to understand, as it can significantly affect their equated monthly instalments (EMIs), the total interest paid, and the loan tenure.
Bank loans are tied to a benchmark rate, which is the lowest rate at which a bank can lend. Banks apply a credit spread over this benchmark. The spread is decided based on factors such as the borrower’s gender, income source, credit score, and loan amount. The benchmark and the credit score form the final rate of interest at which a loan is given.
The MCLR, introduced in 2016 by the Reserve Bank of India (RBI), was intended to ensure that interest rates offered by banks moved rapidly and in tandem with the RBI's repo rate movements. However, this lending rate framework failed to achieve its primary objective. As a result, starting in October 2019, the RBI mandated all banks to link their retail loan rates to an external benchmark, such as the repo rate, which is more transparent and favourable to borrowers.
Adhil Shetty, CEO of BankBazaar.com, says, “The RBI introduced MCLR seven years back in April 2016 to replace the Base Rate system. MCLR is calculated by considering various factors, such as the bank's marginal cost of funds, operating costs, and statutory reserve requirements. It reflected the cost of borrowing for the bank and was meant to be more responsive to changes in the broader economic conditions compared to the Base Rate system. Banks set their lending rates for different types of loans (home loans, personal loans, and business loans) by adding a spread or margin over the MCLR. The spread is determined based on the borrower's credit risk, loan tenure, and other operational costs."
An important factor to understand is that ELBR is more responsive to repo rate changes, which can result in faster re-pricing of loans compared to MCLR. This means that any change in the repo rate will now get reflected faster in your EMIs under ELBR. So, when the central bank cuts rates, the benefits will reach borrowers sooner, and conversely, increases are also passed on faster.
“EBLR was introduced to make the transmission of rate changes more transparent, quick, and responsive to changes in the broader economy for consumers. In this case, an interest rate is tied to an external benchmark rate rather than an internal rate set by the lender itself. The RBI had in 2019 introduced guidelines that require banks to link their lending rates to external benchmarks such as the policy repo rate set by the central bank, the treasury bill rates, or other market-determined interest rates," said Shetty.
Existing HDFC home loan customers may choose to switch to the ELBR system free of charge. However, borrowers must gauge the benefits and potential pitfalls before transitioning. The transparency and prompt changing nature of ELBR might sound luring, but remember, quicker rate revisions may increase the burden in a rising interest scenario. Unlike in MCLR, where rates are reset every 6 or 12 months, in ELBR, changes in the repo rate impact the interest rates immediately.
Does EBLR score over MCLR?
After the RBI mandated banks to link lending rates to EBLR, many banks switched to the repo rate. The repo rate saw many revisions - both cuts and hikes - brought in a change in the lending rates. Now, rate revisions started happening in a much more predictable way. The MCLR, which was predictable in terms of the intervals of rate revisions (for example, once in six months), was internally set by the banks and, therefore, more complex to predict in terms of the quantum of the rate change. Also, with older benchmarks, lenders didn't pass on the rate cuts to borrowers at the same speed as rate hikes. This phenomenon of poor policy transmission, which the RBI has lamented over the years, kept interest rates at elevated levels.
"With EBLR home loans, rate revisions are immediately passed on to the borrowers. After falling to 6.50 per cent before May 2022, home loans have increased to around 9 per cent while the repo stands at 6.5 per cent. The lowest spreads have come down to 1.90 per cent for the eligible borrower, and therefore the lowest rates are now in the 8.40 per cent range," said Shetty.
“So, if your home loan is linked to MCLR and you might be paying a major premium above the market rates. In that case, you may consider switching to an EBLR as the spread over the repo rate has been falling,” added Shetty. New borrowers are benefitting from the lower spread rate than the existing ones. Before you make the switch, check the spread rate offered to you and do your maths to understand how much money you will save.
Shetty said, "If you are a prime borrower with a very high spread (2.5-3 per cent), then it may be wise to refinance to a new repo-linked loan. The low spreads remain fixed for the duration of the loan. If inflation is tamed in the near future and the repo rate falls, the rates would automatically fall under 8% again."
If it is low and your interest rate is at par with the new repo-linked loans, you should stick to the MCLR scheme to avoid refinancing costs. If, in the future, interest rates fall, you can move to a repo-linked loan to benefit from the faster transmission of rate cuts.
Therefore, borrowers should thoroughly assess their current financial situations, future prospects and other relevant factors before shifting from MCLR to ELBR.