When you apply for a home loan, one of the choices you make is whether to opt for fixed or floating home loan. A fixed rate home loan, as the name suggests, carries a fixed rate of interest through the tenure of the loan. However, floating rate loans are pegged to a benchmark and is reset periodically with changes in the benchmark rate. When you decide on home loan interest rate fixed or floating; you must understand what a fixed rate means and what floating rate means; and which is better.
There are a couple of quick things you must understand about fixed or floating home loans in India. Most banks today insist on floating rate loans. While floating rate loans are beneficial when rates are falling, they can backfire if rates go up sharply. Based on where interest rates are currently and how they are supposed to move, you can take a decision on home loan interest rate fixed or floating. Please note that, even in case of fixed rate, there is a clause that rates remain fixed only up to a threshold. Beyond that, fixed rates also float.
What are the pros and cons of Fixed Interest Rate?
In a fixed interest rate loan, the rate of interest, and therefore the EMI, remains constant through the loan tenure. A fixed rate loan brings some distinct advantages. For a person doing financial planning for long term, a fixed rate loan is more predictable over the longer term as the liability is known. Also, they are simpler to understand since the way the bank adjusts the floating rates is quite complex. The thing to remember is that fixed rate loan makes a lot of sense in a rising interest rate scenario.
Let us turn to some of the downside risks of a fixed rate loan. Due to the risk to the bank giving the home loan, the average cost is 100 bps to 200 bps higher on fixed rate loans. That raises your interest cost and EMI. The fixed rate loan can work against you if the rate of interest fall, as you end up paying higher than the market rate. One more disadvantage of a fixed rate loan to a borrower is that they are fixed only up to a point. For instance, if you borrowed at a fixed cost of 8% and the interest rates have gone up to 12%, the banker will insist on a higher payout. Even fixed rates are fixed only up to a point.
What are the pros and cons of a Floating Rate Loan
As the name suggests, the rate of interest in a floating rate loan changes with an underlying benchmark like the 10-year yields, bank rate, PLR etc. Home loans with floating interest rates are generally bound to a base rate; plus, there is a floating rate element. Typically, the changes would be made only if there is a minimum threshold shift in rates. Today, for home loans, floating rate loans are more popular. Let us turn to the pros and cons.
Compared to fixed rate loans, floating rate loans carry lower interest rates and the gap can be 100 bps to 200 bps. The floating rate loans work in favour of the borrower in a falling interest scenario or even when rates are in a range. However, floating rate loans are not too conducive to financial planning as there is uncertainty over the quantum of liability. Also, in a rising interest rate scenario, floating rate loans can be more expensive. Normally, banks offer the borrower the option to either increase the EMI or the tenure; but both have costs.
Floating rate loans may actually be a better choice
Having seen the pros and cons of home loan interest rate fixed or floating, let us see why floating rate loans score in this fixed or floating home loan debate.
- Floating rates entail a lower base cost compared to fixed interest rate loans with the difference ranging from 100 bps to as high as 300 bps depending on risk.
- Banks do not charge prepayment and foreclosure in case of floating rate loans, after a basic time threshold elapses. However, fixed rate loans are subjected to foreclosure charges ranging from 2% to 6%.
- Today, floating rate loans are more common, so investors not only get transparency but also get a much wider palate to choose from. Floating loans are also flexible.
- Remember there is nothing like a totally fixed loan and banks have clauses to convert a fixed to floating rate loan under certain conditions.