When it comes to purchase of a house property, the first thing which hits the brain is a mortgage or Housing loan. And when it comes to housing loan, amongst the decisions which a borrower needs to take is to take is to choose the interest rate option on the loan – ‘Fixed’ or ‘Floating’ interest basis. In order to help the readers to take the right decision, let me first explain what is this whole business behind ‘Fixed’ or ‘Floating’ interest rates.
Fixed Interest rate Loans
A fixed interest rate loan is one whose interest rate is determined not to change for a specified number of years at the time of taking of loan. After the expiry of the specified number of years, the interest rate reverts to the prevailing interest rate in the market and the loan becomes a floating rate loan there after. For example, Bob took a housing loan of Rs. 10 lacs for a 15 year duration. Interest rate on the loan was fixed for the first 3 years at 10% interest rate. It means that for the first 3 years, the interest rate on the loan shall remain at 10% irrespective of prevailing interest rate in the economy. After end of 3 years, the interest rate shall be determined on the respective bank’s interest rate. It can be lower or higher depending upon the rate in place after the expiry of the fixed interest rate tenure.
Floating Interest rate Loans
As the name implies, the interest rate on such a loan is floating. This interest rate option behaves like a floating vessel on water which can go in any direction based upon the direction of the underlying water currents. The interest rate applicable to such loan can either increase or decrease based upon the prevailing interest rate in the economy. If you took a loan of Rs. 10 lacs for 15 years at 10%, the interest rate on the loan is valid only till the bank doesn’t change it. The banks have an option to increase or decrease it at any time without providing the borrower a notice.
What Option to Choose and When
This is one of the most frequently asked question when a person is about to enter into a loan transaction and the right option depends upon individual circumstances and the prevailing economic scenario. I have tried to enumerate a few points which may help you in choosing a right option for your loan :
– Interest Rate Hedge : Fixed interest option is basically there to protect borrowers from a rising interest rate scenario. Lets take two parallel scenarios. John takes a home loan with fixed interest rate option @10%. Bob takes a home loan of same amount but with a floating interest rate option @9%. If interest rate goes by 2%, then Bob would have to pay interest @ 11%, but John is protected under his fixed interest rate option and hence would continue to pay interest @ 10% only.
– Difference between Fixed and Floating Rate : You should always try to see how much is the difference between the fixed and floating rate interest option. Generally fixed rate options are 1-2% more than floating rate options (in India). Further, the duration for which the interest rate would be fixed is generally not more than 3 years. In above example, if you were Bob (with interest rate @9%) and had an option to go for Fixed interest rate option of 11% (fixed for 2 years only), then you may want to avoid going for fixed option if you anticipate that the interest rate in the economy may not increase by 2% in next two years.
– Certainity of Cash Flows : Fixed rate loans are a darling for people who want to fix their monthly cash outflow for the duration of fixed rate. In countries outside India where a fixed interest rate options are available for upto 7 years, this is an excellent choice for people who want to know right at the time of taking a loan as to how much they need to pay for next 5-7 years irrespective of interest rate scenario. On the contrary, floating rate loans always has an uncertainity of how much would be the monthly payout if the interest rate goes up as they are directly linked with the interest rate tagged to the loan.
– Prediction of Interest Trend : If you are in an economy where interest rates are predicted to be going down for next 1-2 years, you should opt for flexible interest rate option. For example, the scenario currently in India may justify a flexible interest rate option so that the amount being paid back on loan reduces with every reduction in the interest rate.
This is a place where at times I believe that Indian banking industry doesn’t do a fair play. They offer fixed interest rate loan option when the interest rates are on a down trend and they then market it heavily to attract gullible borrowers. This ends up benefiting the bank rather than the borrowers as the bank asks for a higher interest rate for fixed interest rate options. Further, the banks just provide maximum upto 3 years of fixed interest options. I really fail to understand why can’t they provide options upto 5 years as in other countries!
On the contrary when the interest rates are going up, all fixed rate options vanish in the air ! This is the time when the borrowers need to protect their monthly outflows by going with Fixed interest rate options, but unfortunately the lenders in India are not happy / interested to protect the borrowers.
Majority of the Indian borrowers can’t really go outside India to borrow for their requirements and hence have to choose in what ever options they have in India. In such a scenario, they should really make an intelligent decision to opt for an interest rate option which aims to protect their cash outflows without significantly hurting their purses.