The Link Between MCLR and Credit Score

Credit Score and the Marginal Cost of Funding-Based Lending Rate (MCLR) are closely related. MCLR is the lending rate charged by banks and credit score is a numerical representation that shows your creditworthiness. To understand the link between the Credit Score and MCLR, let us first understand both these terms in detail.

What is MCLR?

The MCLR stands for Marginal Cost of Funding-Based Lending Rate. It is a minimum interest rate at which a bank lends, below which, the bank is not allowed to lend. It was established in 2016 by the RBI as a replacement to the old system of Base Rate of interest on loans. With the establishment of the MCLR system, all previous base rate linked loans and credit exposures have been migrated to the new MCLR regime. The RBI has set up a facility to link the base rate for loans given by banks to the MCLR system starting 1st of April 2018. This will benefit borrowers who have borrowed on base rate.

The MCLR is derived from the following factors:

  • The marginal cost of funds
  • Tenor premium (which pays off the risk on long-term loans)
  • Operating expenses
  • Cost of Cash Reserve Ratio (CRR)

The traditional base rate system is derived from the average cost of funds and the minimum rate of return. MCLR reflects the Repo Rate set by the RBI. A Repo Rate is the rate at which commercial banks borrow money from the RBI when they are running short of funds. This means that lower the repo rate, lower will be the interest rate at which commercial banks float a loan to the borrowers. Therefore, MCLR helps in passing on any changes in policy rates set by the RBI to the banking customer.

After the announcement of linking all base rate linked loans to the MCLR regime after 1st April 2018. All loans will be based on the MCLR system post-March 2018. As directed by the RBI, the MCLR applicable on any type of loan has to be in a 1-year rate or of a lower tenure. Banks have an option to choose either a six month or a standard 1-year MCLR. Banks also have the option to add a small percentage of interest over the MCLR for any of the loans offered. This implies that the interest rate of the loan will be reset as per the benchmark MCLR on an annual basis, provided it is a floating rate loan or a fixed loan less than 3 years in tenure.

Let us illustrate this with a simple example. Bank A has set its 1-year MCLR at 9.2%. You have decided to take a personal loan in June 2020 at a floating rate of interest. The bank decides to add a small percentage of interest equivalent to 25 basis points. Thus, the final rate of interest offered by bank A to you will be 9.45%. Taking this into consideration, if the MCLR slumps to 9.1% next financial year, the interest rate offered by Bank A will come down to at 9.35%.

The existing loans will continue to be dependent on the base rate. Existing customers could shift to MCLR-based loan, depending on the bank agreeing to it.

What is a Credit Score?

A Credit Score or CIBIL Score is a three-digit number that ranges from 300 to 900 and is generated by TransUnion CIBIL based on the repayment history of the borrower as per the records in their credit report. This score indicates the creditworthiness of the individual i.e. their capacity to repay the borrowed credit. This is evaluated by every lender and credit card issuer before offering you any credit product. Basically, this score helps determines if you are a good borrower or not.

How MCLR and Credit Score are Linked?

There is no such specific or direct relation between the MCLR and Credit Score. But your credit scores impact your chances of getting a loan at the MCLR-based interest rate. If you have a high credit score, you don't need to worry about loan rejection. But if you have a low credit score, banks will most likely reject your loan and even if you get the loan you will be charged a very high rate of interest. So, it is advised to keep your scores at the top to get the loan at the MCLR regime.

In a nutshell, these two aspects are not related directly, yet your credit score holds great importance in your financial life. As it indicates whether you are eligible to get a loan at the MCLR based interest rate or not.