Are you one of those who are always confused over why different banks offer different rates of interest for loans? Have you ever wondered why one bank is earning more interest than others for the same amount of home loan? If yes, then read on to get a detailed explanation of loan interest rates.
To know more about how loan interest rates are calculated, let us first understand how Banks function. As you know banking is all about taking and giving money to people. Banks give you interest on the money you deposit and they charge interest for the money you borrow.
In simple terms, the difference between these two interests is income for the bank. In order to maximise their income, every bank would want to charge maximum interest on loans and give out less interest for deposits. Makes sense, right?
This is on the revenue side, but what about their costs?
Well, every bank has a different cost structure. It is evident that bigger banks have more efficient cost structures. This is why some of the biggest banks have the lowest interest rates.
All banks stack up their minimum profit over this cost and they arrive at a minimum lending rate. This is the minimum rate of interest that a bank can offer to anyone i.e. Cost + Some Minimum Profit.
All this is fine, what has this got to do with How Banks Calculate Interest for Loans?
The interest rate that you pay to the Banks can be of two types- Fixed and Floating. Here is what they mean:
- In case of fixed interest rate, the interest remains constant throughout the loan period irrespective of the changes in market conditions.
- In Floating interest rate, the interest can increase or decrease depending on market conditions.
RBI has specifically asked all the Banks to only offer Floating Interest Rates. But on what basis does this Interest Rate Floats? Is there like a general formula or is it like Coke’s secret – hidden in the vaults.
Nothing of that sort! But broadly this is how Bank’s Floating Interest Rate changes
Bank’s Secret Formula for Interest Rates
Floating Interest Rate = MCLR + Spread
Here MCLR means Marginal Cost of Funds based Lending Rate (MCLR). It is the minimum lending rate below which a bank is not permitted to lend. A bank can have multiple MCLRs – overnight, monthly, 3 months, 6 months etc. If your loan is linked to 6 months MCLR then your loan interest rate will change every 6 months. Simple!
The second component i.e. Spread depends on your credit worthiness. The higher your credit score, the lesser the spread added to your floating interest rate. If your credit score doesn’t change during the tenure of your loan, your spread will also remain constant throughout.
Therefore, if the bank’s MCLR is decreased, your effective loan interest rate will also reduce.
There was an interesting phenomenon noticed in the early 2020s. Almost all the Banks started reducing their MCLRs throughout 2020. One would think that the interest rates for Loans would have also gone down with the reducing MCLRs. But that was not the case!
It has been noticed that Banks are very prompt on passing any type of increase in MCLRs, but there is always a lag in case of reduction. In certain cases it doesn’t happen at all. This is why it is important for you to keep a track of your Bank’s MCLR – in case you have a Loan.
But How and When do the bank’s MCLRs change?
There are many factors affecting the MCLR but the most important factor that determines MCLR is the repo rate set by the RBI. In the last 6 months, repo rates have been increased by 0.80-1.00% and MCLRs for all banks have increased by the same number.
One would think that if interest rates are rising, shouldn’t the interest rates that I get for Savings Account and FDs also rise proportionally? And you wouldn’t be wrong.
Ideally the interest rate rise in Savings and FD should be in conjunction with the Loan Interest Rates. But alas! that is not the case.
In 2020, when RBI reduced the repo rate, banks took a long time to reflect it in the lending rates for the borrowers and in some cases this benefit was not at all passed to them.
Under the MCLR regime, banks must adjust their interest rates as soon as the repo rate changes. All banks are supposed to benchmark their floating interest rate as per the repo rate.
#1 Tip for you: If you have a loan with floating interest rates, you can ask your bank to link it with Repo Rate instead of MCLR and the repo rate cuts will start reflecting in your interest rate.
Some Other Tips for Best Interest Rate
After this entire cognisance about interest rates, I am sure you are in a better position to negotiate with the banks while borrowing loans. Let us now conclude with some tips that you can use to get the best deals from banks:
- Maintain a high Credit/CIBIL score. If you don’t have a good score right now, you can amend your financial activities and increase your score in few months.
- Generally, large PSU banks (SBI, PNB) offer lower interest rates. Make sure to get a quote from these banks also before finalizing.
- Make Banks compete with each other. Negotiate with multiple banks citing lower rates from other banks. Ultimately, banks also have targets and you are helping them meet their targets.
Let us know in the comment section if you are also trying to get a loan, we will try to cover some bank specific tips on how to go about reducing your interest rate.