Repo Rate vs MCLR: Understanding Your Home Loan EMI Hike

Many homeowners often find their home loan EMIs increasing, leading to confusion and financial strain. This phenomenon is directly linked to changes in key interest rates set by the Reserve Bank of India (RBI) and how commercial banks benchmark their lending. The two most prominent terms in this discussion are the Repo Rate and the Marginal Cost of Funds based Lending Rate (MCLR). This comprehensive guide will demystify these terms, explain their intricate relationship, and clarify why your home loan EMI might have increased.

What is the Repo Rate?

The Repo Rate is the interest rate at which the Reserve Bank of India (RBI) lends money to commercial banks in India. It is a crucial tool in the RBI's monetary policy to control liquidity and inflation in the economy.

• When the RBI increases the Repo Rate, it becomes more expensive for banks to borrow money, leading them to increase their own lending rates.
• Conversely, a decrease in the Repo Rate makes borrowing cheaper for banks, often resulting in lower lending rates for consumers.

The Repo Rate acts as a benchmark for the entire banking system, signaling the direction of interest rates in the economy.

What is MCLR (Marginal Cost of Funds based Lending Rate)?

The MCLR is an internal benchmark lending rate for banks, introduced by the RBI in April 2016. It replaced the Base Rate system and was designed to improve the transmission of policy rate changes (like the Repo Rate) to borrowers.

MCLR is determined by several factors, including:

• Marginal cost of funds (the cost of borrowing funds for the bank, like deposits)
• Negative carry on account of Cash Reserve Ratio (CRR)
• Operating costs
• Tenor premium (additional charge for longer loan tenors)

Banks set different MCLR rates for various tenors (e.g., overnight, one month, three months, six months, one year). Most home loans are linked to the 1-year MCLR. Your home loan interest rate is typically MCLR + a spread (a fixed margin charged by the bank).

The Interplay: Repo Rate and MCLR

The Repo Rate significantly influences the marginal cost of funds for banks. When the RBI increases the Repo Rate, banks' cost of borrowing from the RBI goes up. This, in turn, pressures banks to increase their MCLR to maintain profitability. Consequently, if your home loan is linked to MCLR, a hike in Repo Rate will eventually lead to an increase in your loan's interest rate.

Understanding Transmission Lag: Why Your EMI Doesn't Change Instantly

This is where many borrowers experience confusion. Unlike some other loans, MCLR-linked home loans do not see an immediate change in interest rates when the Repo Rate or even MCLR itself changes. This is due to what is known as transmission lag and the loan's reset clause.

• Banks typically specify a reset period (e.g., 6 months or 1 year) for MCLR-linked loans.
• Your interest rate will only be reset to the new MCLR (plus spread) at the end of this period, irrespective of when the Repo Rate or MCLR actually changed.
• For example, if your loan has a 1-year reset clause and your last reset was in January, an MCLR change in March will only impact your EMI from the next January.

This lag can mean that even if the Repo Rate has been stable or has even decreased, your EMI might still increase if your reset period coincides with a past MCLR hike. Conversely, if rates are falling, you might have to wait for your reset date to benefit.

Why Your Home Loan EMI Increased (MCLR Perspective)

Putting it all together, if you have an MCLR-linked home loan, your EMI likely increased because:

• The RBI increased the Repo Rate, making funds more expensive for banks.
• Consequently, your bank increased its MCLR (to which your loan is linked).
• Your loan's interest rate was reset to the new, higher MCLR on your specified reset date, leading to an increased EMI (or a reduced tenure, depending on your loan terms).

The Shift to EBLR: External Benchmark Linked Rate

Recognizing the issue of slow transmission under MCLR, the RBI mandated all banks to link their new floating rate retail loans (including home loans) to an External Benchmark Linked Rate (EBLR) from October 1, 2019. The most common external benchmark chosen by banks is the RBI's Repo Rate.

EBLR loans are characterized by:

• Greater Transparency: Directly linked to an external benchmark, making rate changes more predictable.
• Faster Transmission: Changes in the Repo Rate reflect much more quickly in EBLR home loan interest rates, typically within one to three months.
• Minimal Lag: The concept of a long reset period (like in MCLR) is largely absent or significantly shortened.

MCLR vs. EBLR: A Comparative Glance

If you took a home loan before October 2019, it is likely linked to MCLR. Newer loans are almost certainly linked to EBLR.

What Can You Do About Your Rising EMI?

• Review Your Loan Statement: Check your interest rate reset date and the benchmark your loan is linked to (MCLR or EBLR).
• Consider a Switch to EBLR: If your loan is MCLR-linked, you can inquire with your bank about converting to an EBLR-linked loan. This usually involves a conversion fee but can offer more transparent and potentially faster benefits from falling Repo Rates.
• Explore Balance Transfer: If your current bank's EBLR conversion terms aren't favorable, consider transferring your home loan to another bank offering better EBLR rates. Factor in processing fees and other charges.

• Prepayment: As discussed in our Prepayment Guide, making additional payments can significantly reduce your interest burden, irrespective of the benchmark.

Conclusion

Understanding the dynamics of Repo Rate and MCLR (and now EBLR) is vital for every home loan borrower. While an increase in the Repo Rate typically leads to a hike in your EMI, the exact timing and impact depend on whether your loan is linked to MCLR-linked or EBLR-linked, and its specific reset clause. By staying informed and exploring options like switching to EBLR or making prepayments, you can better manage your home loan and mitigate the effects of rising interest rates.