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Banks use various benchmark rates to determine loan pricing. Initially, they had complete discretion over interest rates, leading to the adoption of the Prime Lending Rate (PLR). This internally determined rate was applied to the bank’s most creditworthy customers, with additional risk premiums charged for borrowers deemed riskier. However, this system resulted in a wide disparity in interest rates among borrowers.

To enhance transparency, the Reserve Bank of India (RBI) introduced the Base Rate, a standardized benchmark computed using four components: the cost of funds (interest payable on various sources of funds), operational expenses, the cost of maintaining the Cash Reserve Ratio (CRR), and the bank’s profit margin. The intent behind this reform was to ensure that changes in RBI’s policy rates were transmitted to borrowers in the form of corresponding adjustments in lending rates. This process, known as Monetary Policy Transmission (MPT), was not functioning effectively under the Base Rate system due to banks’ reluctance to adjust rates.

To address this, RBI introduced the Marginal Cost of Funds-Based Lending Rate (MCLR) in 2016, linking lending rates more directly to the RBI’s policy rate—the Repo Rate, which is the rate at which RBI lends to banks. Three key changes were implemented in the MCLR formula: (1) replacing the cost of funds with the marginal cost of funds, (2) including the bank’s return on net worth as part of the marginal cost, and (3) allowing for tenor-based adjustments based on loan duration.

The marginal cost of funds reflects the weighted average rate at which deposits of similar maturities were raised before the review date. It consists of two components: Return on Net Worth (8%) and Marginal Cost of Funds (92%). The formula for MCLR is:

MCLR = Marginal Cost of Funds + Operating Cost + Negative Carry on CRR + Tenor Premium/Discount

Marginal Cost of Funds = (Average cost of funds at a cutoff date) x 92% + (Return on Net Worth) x 8%

Although MCLR improved loan pricing transparency, between 2016 and 2019, banks were slow to pass on rate reductions to borrowers. Additionally, some elements of the MCLR formula allowed for subjectivity. To address these limitations, RBI introduced the External Benchmark Linked Rate (EBLR) in 2019. Under EBLR, loan interest rates are directly linked to an external benchmark, such as the Repo Rate, 91-day or 182-day Treasury bill yields, or any other RBI-approved benchmark, instead of an internal calculation.

With EBLR, the loan interest rate is determined as:

Loan Interest Rate = External Benchmark + Spread (including profit margin, operating costs, negative carry on CRR, and risk premium).

This shift has resulted in greater transparency, instant transmission of rate reductions, and uniformity in loan pricing.

Currently, banks use EBLR for most retail loans, particularly long-term home loans. These have become “floating rate” products, where borrowers pay higher or lower interest based on changes in the Repo Rate. In February 2025, RBI’s Monetary Policy Committee (MPC) cut the Repo Rate by 25 basis points (bps) for the first time in five years. The last reduction occurred in May 2020, when the rate was lowered by 40 bps to 4%. Since June 2022, the Repo Rate had risen beyond 5%, stabilizing at 6.50% through 2023 and 2024.

Following this cut, SBI has revised its EBLR effective February 15, with other banks expected to follow. Home loan borrowers should see a reduction in their EMIs, providing financial relief amid rising prices and inflation. RBI Governor Sanjay Malhotra emphasized that “the MPC, while maintaining a neutral stance, believes a less restrictive monetary policy is more appropriate at this juncture.” Consequently, further Repo Rate reductions are anticipated in the coming quarters of FY 2025-26.

Given global geopolitical tensions and trade challenges, RBI is focused on infusing liquidity into the economy. The 0.25% Repo Rate cut, alongside other measures, aims to stimulate growth. Additionally, the Union Budget has introduced zero income tax for individuals earning up to ₹12 lakh, benefiting salaried individuals. This, combined with lower home loan interest rates, is expected to positively impact the real estate sector in the upcoming fiscal year.