Meaning of Spread/Mark up in Bank loan rates

In banks, the markup is the value added to the cost of funds used for lending as Spread or mark-up broadly: profit.

Banks are free to decide the mark-up or spread over the cost of funds. As per RBI guidelines, banks shall adopt the following broad components of spread:

(i) Business strategy: The component shall be arrived at taking into consideration the business strategy, market competition, embedded options in the loan product, market liquidity of the loan, etc.

(ii) Credit risk premium: The credit risk premium charged to the customer representing the default risk arising from loan sanctioned shall be arrived at based on an appropriate credit risk rating/scoring model and after taking into the consideration customer relationship, expected losses, collaterals, etc.

Banks are not allowed to lend below their MCLR (Marginal Cost of Funds based Lending Rate) but are allowed to charge a mark-up or a spread over their MCLR. Currently, very few banks lend at MCLR while most of them have a spread. The value added is called the mark-up. The mark-up added to the cost price usually equals retail price. For example, a bank adds 25 basis points (or 0.25%) on its MCLR of 7.00% then the borrower will be charged interest at 7.25% on his home loan. Banks are free to decide the spread over the cost of lending.

As per RBI guidelines, the spread charged to an existing borrower shall not be increased except on account of deterioration in the credit risk profile of the customer. Any such decision regarding the change in a spread on account of change in credit risk profile shall be supported by a full-fledged risk profile review of the customer.