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To float or not to float, that is the question!

This article discusses the pros and cons of floating and fixed interest rates for home loans, and helps you choose between the two.

Buying a home is one of the main goals for most of us (Please read “Goal Based Investing” for more details). And home loans have made buying a home really easy, even for people just starting out in their careers (Please read “Settle early in life – buy a home when young” for more details).

The rate of interest is of prime concern for people taking a home loan. But that is something over which we as home loan takers do not have much control.

But we do have control over the type of interest rate we opt for. And this is one of the biggest dilemmas that people face while taking a home loan – what kind of interest rate to go for? Should you go for a fixed rate loan, or for a floating rate loan?

Let’s look at both, and see what each has to offer.

 

Fixed Interest Rate Home Loan

In this type of home loan, the rate of interest remains fixed throughout the tenure of the loan. Irrespective of the interest rate movements in the market, the rate remains the same as that contracted during the start of the loan.

For example, if the fixed rate home loan is given at 9.5% rate of interest, the interest rate would remain at 9.5% even if the market rate goes up to 11%, or if the market rate goes down to 7.5%.

Advantages

  • Fixed Outgo: Since the rate of interest is fixed, the EMI remains fixed. Therefore, you know the exact monthly outgo on the EMI, and can budget accordingly.
  • Protection against adverse interest rate movement: The rate of your loan remains the same even if market rates move up. This means you are protected from higher interest rates.

Disadvantages

  • Can’t take advantage of lower interest rates: Even if the interest rates in the market go down, you would be stuck with your interest rate – you would not benefit from lower rates.
  • Higher interest rate, Higher EMI: The interest rate charged for fixed rate home loans is usually 0.25% to 1.5% higher than the rate offered on floating rate home loans (The bank is taking a risk by fixing your interest rate for so many years. So, as compensation, they charge a higher rate).Therefore, your EMIs for the same loan amount would be higher in case of fixed rate home loans, and you would also end up paying a lot more as interest during the tenure of the loan.

Money Market Clause

This is something that can bring a twist in your fixed rate home loan, so it is very important to know about it.

Many banks have a clause in their agreement, which states that in case of adverse market movements, the bank has the right to adjust your interest rate.

What does this mean? It means that although your loan is supposed to have a fixed rate, the bank can change the rate! The clause doesn’t specify exact events for which the bank can change the rate, so it is very open ended, and blatantly favours the bank.

Therefore, if you are negotiating for a fixed interest rate home loan, find out if the bank has such a clause. If yes, try your best to convince the bank to remove it!

 

Floating Interest Rate Home Loan

As the name suggests, the interest rate in a floating rate home loan keeps “floating”, or keeps changing.

In theory, the rate would fluctuate with the change in the prevailing interest rates. Thus, if prevailing interest rates go down, the interest rate on your loan goes down too, and the same way, if the prevailing interest rates go up, the interest rate on your home loan goes up.

There is a fixed interval, usually six months, when the interest rate on your home loan is reset depending on the prevailing interest rates.

In practice…

Now, I hope you noted that I said in throry, the rate would fluctuate with the change in the prevailing interest rates.

Why did I say so? It is because the methodology used by the banks to judge the prevailing interest rates and to reset the interest rate on your home loan based on it is totally non-transparent. And therefore, in the past few years, it has been observed that the floating rate on the home loan goes up if the prevailing interest rates go up, but doesn’t go down if the prevailing rates go down! Now that is skewed!!

Ideally, the floating rate should be tied to a market determined, transparently derived interest rate benchmark, like the MIBOR (Mumbai InterBank Offered Rate), so that the floating rate truly goes up and down according to the movement of interest rates in the market.

But what the banks do is that they tie the floating rate on your home loan to their internally defined Prime Lending Rate (PLR). They don’t disclose the methodology to calculate this, and it remains totally at their discretion. And they increase this PLR (and therefore your floating rate) when interest rates go up, but don’t decrease the PLR (and therefore your floating rate) when interest rates go down!

So, it ends up being a one sided bet, in which you are certain to lose!

Interest rate change and effect on EMI / Tenure

When the floating rate on your home loan changes, there are two ways in which it can affect you: Either the EMI could change, or the tenure of the loan changes.

Thus, if the rate is revised upwards, either your EMI would increase, or the tenure of your loan would get increased to accommodate this change. In most cases, you won’t have a choice, and it would depend on the bank’s policy – most banks change the tenure of the loan.

Advantages

  • Lower interest rate: The interest rate on floating rate home loan is less than fixed rate home loans. (This is because you are taking up the risk of interest rate movements).

Disadvantages

  • All risk is yours: Although excellent as a concept, due to the way in which the banks calculate the floating rate, you end up taking all the risk.

 

Hybrid Loans – A combination of fixed and floating

Most banks also give you an option to go in for a combination of these two – for example, if you want a home loan for Rs. 20 Lakhs, you can take the loan for Rs. 10 Lakhs on a floating rate, and for the remaining Rs. 10 Lakhs on a fixed rate. It can be in any combination, not necessarily 50-50.

This option is suitable for people who want benefits of both fixed and floating rate loans!

 

My Opinion

If the floating interest rates are implemented the way they should be, the choice between fixed and floating rates should be made depending on the prevailing and probable interest rate scenario.

But in the present form – where the benchmark (bank’s PLR) is opaque and distorted – I strongly favour fixed rate loans – they are definitely a better option. Even if it means paying a higher interest rate, it is a price worth paying for avoiding all the risk associated with the floating rate loans prevailing today.

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