What are the effects of increasing MCLR on loans and investments?
But before going into MCLR, we have to get some basics right about FD’s and loans.
What effects interest rate of FD and home loan?
Before Apr’2016, Base Rate of individual banks used to decide the interest rate of FD and home loan.
What was base rate?
Base Rate was a calculated rate of interest below which a bank cannot lend money.
After 01-Apr’2016, Base Rate methodology was replaced by MCLR.
What is MCLR?
This is another financial jargon like Base Rate.
The difference lies in the way both are calculated.
It is said that, Marginal Cost of Funds Based Lending Rate (MCLR) is calculated in such a way that, any change in RBI’s Repo Rate will be immediately reflected in MCLR.
If Repo Rate is decreased, MCLR will also decrease immediately and vice versa.
It means, its effect on our FD and Bank Loans (home & car loans) will be felt much quicker.
In last few years, we saw that though RBI was reducing the Repo Rate, but the banks were not transferring the benefit to us.
But it is now assumed that, with introduction of MCLR, Banks will be forced to pass on the benefits immediately.
#1. MCLR since May’2016
Since May 2016, MCLR rate of SBI has come down from 9.3% to 8.35% in Mar’18.
In last 20 months (May’16 to Dec’17), the MCLR has seen only a falling trend.
But in last couple of months, increasing MCLR regime seems to be back in business.
In Jan’18 MCLR of SBI was 8.1%. Now in Mar’18 it is 8.35%.
What is the effect of MCLR?
On one side, home loan becomes expensive and on other side the FD rates becomes more attractive.
When SBI starts increasing their MCLR, we common people should worry or do what?
What alteration we must be ready to do in our financial planning.
Alterations that are most visible are following:
- Home loan transfer to banks providing cheaper loans?
- FD becoming more attractive, should divert some funds from equity to FD?
- As bonds prices are falling, should switch bond linked mutual funds?
But all these actions can be taken once we understand clearly the mechanics of MCLR (repo rate) changes….
So lets ask a very important question first….
#2. Why MCLR Rate has gone up?
On 01-April’2016, Base Rate method was replaced by MCLR.
Since then, banks like SBI has only reduced their MCLR (see above chart).
In year 2018, it is for the first time that the bank’s have increased their MCLR since the preceding month.
What has changed lately that is forcing banks to raise MCLR?
As per last figures of RBI, total NPA’s (Non Performing Assets) on Indian banks is 7.34 Lakh Crores.
With issues like Nirav Modi and Rotomac propping up, RBI is coming heavily on Indian Banks (specially Government banks).
What RBI is saying to the Banks? RBI wants banks to increase “Provisioning on Loans”.
What is provisioning on loan?
It means, banks must keep more funds aside.
In case more NPA’s (bad debts) prop up, these set-aside funds will come for the rescue.
But what happens when banks set aside more funds to manage bad debts?
Their profits decreases.
Hence, to increase their profits and profitability, banks must raise their lending rates (MCLR).
Ok, why banks are increasing their lending rate (MCLR) is understood.
But why banks are increasing interest rate on FD’s?
This way they are only increasing their expense, right?
Banks do not have a choice. In order to increase MCLR, they must first increase the deposit rates.
This can be understood from the below formula:
MCLR rate = Rate of Deposits + CRR + Operating Cost + Tenor Premium.
It is interesting to understand the effect of inflation on MCLR.
Though Inflation and MCLR has only a weak direct link, but both change almost in tandem.
Lets see how…
- Nov’13, Inflation was @11%, and 10Y Govt Bond Yield was at 9%.
- Aug’17, Inflation was @3.4%, and 10Y Govt Bond Yield was at 6.77%.
- Mar’18, Inflation is @5.0%, and 10Y Govt Bond Yield is at 7.75%.
So with change in inflation rate, the Govt. bond yield also changes.
- When Inflation is falling, bond yield also falls.
- When Inflation is rising, bond yield also rises.
This increase in inflation makes the market riskier for the investors.
Here they start to flee the bond market. This makes the bond prices to fall.
To increase the demand, bond yield is increased.
But increase of Government bond yield is good for investors, but it is not good for the Indian Government.
Higher bond yield means, government has to pay more interest to the investors.
This creates negative sentiment in the market as investment risk increases.
When Government bond yield increases, RBI is forced to increase its Repo Rate (to compensate for their bond interest payment load).
Repo rate increasing means, MCLR will also go up.
#3. Effects of increasing MCLR..
The main ill effect of increasing MCLR is felt by loan borrowers.
Frankly speaking, there is very little a borrower can do to prevent self from increasing MLCR.
But there is a small get-away one can try.
Generally when banks sanction a loan, it can be linked to MCLR in the following ways:
- 6 month MCLR, or
- 12 month MCLR.
What does it mean?
Suppose you took a home loan today.
Today RBI increases its Repo Rate. In this case the banks will also increase its MCLR. Which means the home loan rate will also increase. But 6/12 month MCLR will work like this:
- 6 month MCLR – Loans granted on this MCLR will remain fixed for next 6 months. Only after lapse of the 6th month, banks will be able to increase the loan interest based on revised MCLR.
- 12 month MCLR – Loans granted on this MCLR will remain fixed for next 12 months.
Hence in increasing MCLR regime, 12 month MCLR may prove more beneficial.
But in decreasing MCLR regime, 6 month MCLR will prove more beneficial.
Lets see some effects of Increasing MCLR on FD’s and debt funds…
#3.1 Fixed Deposits
Bank Fixed Deposits rates are sure to increase in coming months (Mar’18 and forward).
Though one should not expect any major hikes. The rate hike will be gradual over a period of time.
In such a situation where FD rates are expected to continuously increase, what should be ones investment strategy?
Do not commit all free cash to a FD with long term locking period.
Better will be to stay invested for 3-6 months and then liquidate.
If Interest rate increases, put the liquidated fund back to FD.
Let your funds roll from one FD to another earning higher interest rates.
Though, one must keep a track of RBI’s Repo Rate which eventually controls the bank’s MCLR.
#3.2 Debt Linked Mutual Funds
When inflation increases, yield of 10 Year Government bonds also increases.
But this is not a good sign. Why?
To know this, lets understand the working of Bonds.
Suppose there is a Government Bond whose Par Value is Rs.1,000. Say, this bond will always pay an interest of Rs.100 per annum (10% on its Par Value).
These bonds are then traded in the market.
The market price of these bonds can be above or below its Par Value.
There can be three scenarios here:
- 1,000 is the market price of Bond. If a person purchases a bond at this price, he will continue to receive Rs.100 per annum till its maturity. Here the bond yield is 10% (100/1000).
- 900 is the market price of Bond. If a person purchases a bond at this price, he will continue to receive Rs.100 per annum till its maturity. Here the bond yield is 11.11%(100/900).
- 1,100 is the market price of Bond. If a person purchases a bond at this price, he will continue to receive Rs.100 per annum till its maturity. Here the bond yield is 9.09%(100/1100).
When inflation increases, market sentiment goes down.
This decreases the demand for the Government Bond. It means there are less buyers.
Less demand means, the price of bond will fall.
When market price of bond will fall (say from Rs.1000 to Rs.900), though the yield of Bond increases, but the reason behind the fall in bond price is alarming.
So how it corresponds to our MCLR analogy?
Increasing MCLR means, inflation in increasing. It leads to less demand for bonds.
Hence, those investors who invest in debt linked funds (which invests in Government Bonds) will have tough times ahead.
They may end up selling their bonds at price less than their purchase price.