Fixed Rate Loans vs
Floating Rate Loans (sometimes these are also called Variable Rate Loans by
bankers) is a dilemma faced by almost every Home Loan buyer. If you talk to 10
people who have already availed Home Loan, you will find that they too are
divided on the issue. Now if you talk to hard core banker, he too is likely to
be evasive on the issue, as with all the knowledge at their, no one can predict
100%, as to which of these two rates will be beneficial in the long run.
Therefore, it is necessary that you understand the basics of these type of
schemes and finally take a call based on your judgment and current scenario.
Now we will try to explain the benefits and disadvantages of each type of such
loans.
Fixed Rate of Interest Loans
Floating Rate of Interest Loans (or Variable Interest)
Definition
Fixed Rate of Interest loans are those in which the interest rate
charged on the loan remain fixed for the loan's entire term, no matter
how interest rates change during the tenure of the loan.
(These days most of the banks do not allow fixed rate for entire period
of loan but only for first 3 to 10 years. In such cases at
the end of your fixed interest rate term you can either choose a new
fixed rate of interest from the rates available at that time, or change
to a floating interest rate.)
The longer the tenure of the fixed loan, higher will be the marked up
rate of interest for such loan. For example, for fixed loans with a
tenure of 3 years rate of interest is say 10.25%, but it will be higher,
say 10.50%, if the tenure of the loan is 10 years.
Floating interest rate loans or Variable interest rate loans, as the
name implies, are those loans where the interest rate varies with
market conditions. Such loans are these days tied to a Base Rate + a
given interest rate. . Thus, as and when the Base Rate varies the
floating interest rate also varies. To understand, it better, let us
say you are sanctioned a housing loan on floating rate basis and
interest rate to be paid by you is Base Rate+1.5%. In case the current
Base Rate of the bank is 10%, then you will have to pay 11.5%
(10%+1.5%). Suppose Base Rate is increased by bank after 6 months to
10.5%, then your interest rate will automatically will increase to
12%. Similarly, in case Base Rate is reduced to say 9%, then interest
rate charged from you will be only 10.5%
Which Type of Interest Rate is lower / higher at the start of the loan.
Why is it so?
At the beginning of the loan, the rate of interest charged is higher
than the floating rate of interest.
The reason for charging higher interest rate in fixed rate loan is due
to the risk taken by bank for losing if the interest rates go up
substantially during the entire period of loan.
At the start of the loan, the rate of interest under floating rate is
lower than the fixed rate of interest.
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Benefits
(a) Interest rate remains fixed irrespective of market conditions. Thus, if interest rates rise substantially, your fixed rate may be even less than the floating rate in the future.
(b) It gives a sense of security as you are aware that rate of interest will not go beyond the fixed rate of interest
(a)It allows you to take advantage of the downward trend in the interest rate market.
(b)Your EMI will go down if there is substantial fall in the interest rate in the market
(c)In case of floating rate of interests, RBI does not now allow any penalty for pre-payment and thus, you can save interest if you have surplus funds during the tenure of the loan.
Drawbacks
(a)As mentioned above, fixed rate of interest, at the start of the loan, are usually 1% to 2.5% higher than the floating rate home loan. Thus, your current EMI is more than if you opt for floating rate of interest.
(b)In case the interest rate decreases in the future, the fixed rate home loan doesn't get the benefit of reduced rates and the borrower has to repay the same amount every time.
(c)Some banks may charge pre-payment penalty in case of fixed rate of interest scheme.
(a)In the case of floating interest rates, your EMIs are likely to change as interest rate market rises or takes a dip. This makes it difficult to budget with floating interest rate
(b)There is always uncertainty about the future rate of interest on the loan already raised by you..
Conclusion : What is the
Major Difference Between Flxed Rate of Interest Loans and Floating Rate of
Interest :
The
major difference between these two type of loans is the party which bears the
risk of future changes in the interest rate market. In a fixed rate loan, the
bank bears the risk of the rates going up in the future, while in a floating
rate loan, the borrower bears this risk.
Which
Rate of Interest is Better :
As
mentioned in the beginning, it always is dilemma as movement of interest rates
in future can not predicted with certainty by anyone due to dynamics of the
financial world. However, financial experts always keep on guessing and try to
project the future scenario of interest rates. Thus, if you have kept yourself
updated with such projections, you can take a decision based on such projects,
or else it is recommended that you should opt for a floating rate of interest.
At
the beginning of 2015, when we have written this article, the Indian financial
scenario indicates that interest rates are likely to soften, and thus in such a
situation, floating rate of interest option is better. Rest it is the
judgement of the individual borrowers.
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