The decision to choose between a floating rate and fixed rate has always been an important one for borrowers.
WHAT IS A FIXED RATE OF INTEREST?
Fixed home loan interest rate is one where the rate does not fluctuate with changes in market forces and is completely market-independent. This rate remains steady throughout the tenure of the loan. In a fixed interest rate scenario, you’ll know exactly how much each instalment will cost you during the loan tenure. Fixed interest rates are a safer bet in a dynamic financial environment as you would know how much you need to allocate monthly towards repayment. Thereafter, the borrower can use their remaining financial resources to meet other goals freely. It also brings a sense of security.
On the other hand, fixed interest rates don’t allow the lender to benefit from the loan when the market rate decreases. Therefore, if you opt for loans with fixed interest rates, your interest rate is likely to be high. Also, while you’re protected from a rise in rates with fixed interest rates, you could lose out on the opportunity to save on your interest expenses. Besides, fixed loans have a pre-payment penalty, making it more expensive for you to save on the interest (by making pre-payments).
WHAT IS A FLOATING RATE OF INTEREST?
Also referred to as ‘adjustable rate home loan’, it is an interest rate that tends to fluctuate with changing market conditions. These interest rates are directly linked with the repo rate, which is the rate at which banks borrow from the Reserve Bank of India; hence, your EMI will vary throughout your loan’s tenure. Floating rate loans are usually set at a lower rate than fixed rate loans, which makes your loan less expensive. In addition, if repo rates fall, they will reflect in your lending rate as well in a matter of weeks. This fall in the interest rate on your loan reduces the cost of the loan. Most importantly, there is no pre-payment penalty for a floating home loan, which means that you have the flexibility of paying back your loan in less time than expected without any additional costs. This again brings down the cost of your loan.
A floating rate will only benefit the borrower as long as the interest rate doesn’t go beyond 11.5 per cent. Beyond this, it can exceed the amount he/she would otherwise have to pay with a fixed rate. Floating interest rates offer little to no predictability as they are highly subjective to market factors. When the interest rates are on the rise, the effect of the rise is transmitted even faster. Due to the constant change in interest rates, it is difficult to determine the exact duration for which the loan would run. This makes calculating the exact cost of the loan right at the outset difficult.
HOW SHOULD YOU MAKE YOUR CHOICE?
According to experts, you should opt for a fixed home loan if your EMI does not exceed 25-30 per cent of your take-home monthly income. Also, fixed loans offer a reasonable measure of predictability to your loan tenure, EMI commitments, and the total interest outflow; hence, if you are uncomfortable with a constantly shifting interest rate, this option will offer more stability.
If there are reliable indications that interest rates might decrease in the future, borrowers should opt for a floating interest rate. Also, borrowers who are willing to take calculated risks and have plenty of time to repay the loan should opt for a floating rate. For instance, if the fixed rate of interest on a home loan of a given amount is 15 per cent, whereas the floating interest rate on a loan of the same amount is 12.5 per cent, the borrower can still save money, even if the market fluctuates and the floating rate increases by 2.5 per cent.
Exception to the rule
Fixed loans may not necessarily be fixed for the entire tenure of the loan. Most lenders offer a semi-fixed loan, which remains fixed for two-five years, and then gets converted to a floating loan. Other lenders may offer a loan fixed for the tenure of the loan, but may retain the option to revise the rate periodically. So you must have a clear understanding of what ‘fixed’ entails.