Home Loan

Fixed rate versus floating rate of interest – What is the difference?

  • October 4, 2021
  • 5 minutes read

Loans offered by banks and non-banking financial institutions are either on fixed interest rate or floating interest rate. Certain banks decide on the type of interest rate based on the loan plan offered, whereas there are other banks who offer only floating interest rates for all their loan plans. Also, there are certain home loan plans where the interest rate is fixed in the initial years of the loan tenure, and is floating interest rate in the last few years of the loan tenure.  

In this blog, we are going to discuss on what is floating interest rate, what is fixed interest rate and what is the difference between floating and fixed interest rate on loans. 

Fixed interest rate 

Fixed interest rate remains the same throughout the loan tenure. Even when the market price fluctuates when RBI changes the rate at which banks can lend and borrow, it does not affect fixed interest rate. EMI amounts are fixed at the time of loan disbursal and remain the same through the loan tenure.  

Since banks cannot revise the interest rate when the market fluctuates and the base rate goes high, the fixed interest rate is 1%-2% higher than the floating interest rate.   

Who can opt for fixed interest rate? 

Individuals who plan their budgets diligently opt for fixed interest rate on their home loan. This is because when the interest rate is fixed, the EMI amounts remain the same throughout the loan tenure. Even when the interest rate decreases in the market, it does not change the fixed interest rate so the borrowers who have opted for fixed interest rates cannot benefit by it.  

Floating interest rate 

Home loans with floating interest rates are tied to base rate. Base rate is determined by RBI and it is changed when the central banking authority – Reserve Bank of India changes the rate at which banks and financial institutions can lend and borrow. When the base rate changes, automatically floating interest rate of a home loan changes.  

One of the benefits of opting for floating interest rate is that there are no pre-payment penalty charges. So, there are no additional charges when you want to switch your home loan from one lender to another. RBI has banned pre-payment penalty charges on home loans under floating interest rates.  

Why does Reserve Bank of India (RBI) offer fixed interest rates and floating interest rates? 

RBI offers two types of interest rates for loans – fixed and floating. Each type of interest rate has its advantages and disadvantages. An individual should choose the interest rates based on a few factors in order to make sure that his/her loan repayment process is smooth. Read on to understand how to choose between fixed and floating interest rate.  

Choosing between fixed interest rate and floating interest rate 

  • Formulating a budget for net monthly income 

When you choose floating interest rate for your home loan, you will have to re-plan your budget every time there is a fluctuation in the market. Especially when the base rate goes high, you will have to pay a higher amount of EMI even if it is a little hard on the pocket. Based on the home loan plan you have opted for and the lender, changes in floating interest rate can change quarterly, half-yearly or annually. Repo rate changes every quarter, so most banks change their floating interest rate accordingly every quarter. When you choose fixed interest rate, you will not be affected by market fluctuations. This means you do not have to re-plan your budget every time RBI changes Repo rate.   

  • Considering the age of the borrowers 

Individuals nearing their retirement benefit from fixed interest rate as there are no surprises in EMIs. Home loan applicants who are in their 20’s have long careers ahead of them and are prone to taking risks. Hence, they can opt for home loans at floating interest rate. 

  • Have a mix of fixed interest rate and floating interest rate 

You can also opt to split between the two types of interest rate in a home loan. Initial years of the home loan can be at fixed interest rate and rest of the tenure you can opt for floating interest rate or vice versa. You can forego pre-payment charges if you opt to transfer your home loan when it is at a floating interest rate.  

  • Based on loan tenure 

If you are planning to take a home loan for short term or medium term (5-10 years), fixed interest rates give you the stability you need in terms of knowing the EMI amounts. But if you opt for a long-term home loan that is over 10 years to 30 years, you will benefit from floating interest rate. The amount of money you save up on 1%-2% interest rate every month can be used to pre-pay your home loan and close it faster.  

For long-term loans banks fix a high interest rate for loans at fixed interest rate. This is because it is difficult to predict the market conditions over a prolong period of time. Which is why it is beneficial to opt for floating interest rates for long-term loans.  

Are you worried about high EMI amount in case of a sudden rise in the base rate? 

We’ve got you covered. 

Most of the banks have a clause in their repayment terms mentioned in the offer letter handed over to the borrower upon sanction of home loan. The clause states the maximum amount that can be increased from one quarter to another. This protects the borrower from defaulting EMI payments due to high EMI amounts. Make sure you check these before accepting the offer letter. In case the lender does not offer such a clause, you can negotiate with your bank manager and include these in your loan offer letter.  

If you opt for floating interest rate, yet want your EMI amounts to be constant when the base rate goes higher, here’s what you can do – 

Contact your bank and request them to have your EMI amounts constant even when the base rate increases. To make this adjustment, the bank will not increase your EMI amount, but increase your loan tenure so you can pay for the increase by way of additional installments.  

Things to keep in mind when you opt for floating interest rate 

Here are a few pointers that you need to tick off when you opt for a home loan at floating interest rate: 

  • Check if your lender has a max cap on the EMI amount in case of rise in base rate. 
  • If you are particular about paying the same EMI amount month-on-month, contact your bank representative to find out if they will increase the loan tenure instead of increasing EMI amounts. 
  • Get to know the benchmark upon which your lender bases the floating interest rate. Some lenders base it on Benchmark Prime Lending Rates (BPLR), others base it on Repo rate. You can also get an idea on how the interest rate has fluctuated in past to gain an understanding of the graph. However, past behavior of interest rate fluctuation is not an indicator of how it will behave in the future.  
  • Check the minimum EMI amount you will have to pay when the base rate reduces. 

Things to keep in mind when you opt for fixed interest rate 

  • Check if the reset clause is present in your loan offer letter. Reset clause states that interest rates will not be fixed throughout the loan tenure. If that is the case, what are the other conditions and how will the interest rate be calculated. 
  • Find out if the interest will be calculated on monthly reducing balance method. In monthly reducing balance method, interest is calculated only on the principal amount that is outstanding and not on principal repaid. When your loan is under monthly reducing balance method, you end up saving on the interest amounts. 
  • Get to know the Annual percentage rates (APR) of your loan. APR includes interest rates, fees and other charges levied on the loan annually. This will help you keep a tab on the other charges you are paying for and prepare for the EMI amounts accordingly.  

Now that you know all about fixed interest rate and floating interest rate, you can decide on what suits you. If you have any questions further, feel free to reach out to us in the comments below.  

Written by: Marketing Fincity

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