Buying a property is one of the largest investment that most of us make in our lives. With the investment requiring significant capital, many of us have to rely on financing institutions to make the scale of investment more manageable for us. Financial institutions offer different financing options that can cover majority of the property cost, which can be repaid in installments or EMIs spread over 10-30 years. Property loans are offered under two main financing options – fixed rate and floating rate. It is important to understand the difference between the two options, as each can have an impact on your overall financing cost, and affect your return on investment.
The Difference between Fixed and Floating Rate
A fixed rate loan is a loan wherein the monthly repayments are equal for the duration of the loan period that you have agreed with the bank. This means that a borrower pays the same amount monthly for the agreed time to the lender. The fixed rate is mostly determined by the amount being borrowed, the period of borrowing, and overall market situation.
A floating rate loan is a loan wherein the rate of interest changes periodically, based on a combination of factors such as the inflation rate, overall economic conditions, liquidity and the Reserve Bank of India (RBI) measures. Banks use the benchmark Prime Lending Rate (PLR) to set the lending rates. As it fluctuates, the floating rates also change accordingly, causing proportionate change in your monthly installs or EMI.
Benefits and Drawbacks of Fixed and Floating Rate Loans
Benefits of Fixed Rate Loans:
Fixed rate loans being "fixed" offer a sense of comfort and certainty related to installments to borrowers. The option shields borrowers from changing market conditions and interest rates, and allows them to pay as per the amount agreed with the bank. This option is ideal for individuals, who are risk averse and do not wish to have any changes to their financial plans.
Drawbacks of Fixed Rate Loans:
Fixed rates loans tend to be more expensive compared to floating rates, as in case of these loans the lender has to assume the risk of any interest rate fluctuations. The higher interest rate charged by the financial institution, is mainly to guard against increase in interest rates by RBI, which will not affect fixed rate loans.
The benefit of acting as a shield to market conditions, starts acting as a drawback for fixed rate loans in a declining interest rate market. Such situations force a fixed rate loan borrower to pay higher interest rates even if interest rates in the broader market are much lower. Given that fixed rate loans are already configured to be higher than floating rate, a decreasing interest rate market can make such loans extremely expensive, driving up the cost of property purchase and reducing overall return on investment for the borrower. Also, as economies mature, the demand for credit tends to show a decline, which pushes down interest rate. If home loans are taken for a period of 20-30 years, it is likely that interest rate in India will show a decline over longer duration, and then confirming on fixed rate over a longer time frame can be risky.
Benefits of Floating rate:
The reason most home buyers prefer floating rate loans is that these loans are 1-2.5% cheaper than fixed rate loans. Thus, in a scenario when interest rates increase by 2%, a floating rate loan taken at 11% can still be cheaper than a fixed rate loan taken at 13.5%. Also, when interest rates fall, borrowers can gain significantly by choosing to lower installments, or by reducing the loan tenure by continuing to pay the same installation or EMI.
Drawbacks of floating rate:
A floating rate is not predictable, and is completely governed by market forces. When the interest rates shoot up, borrowers are asked by banks to pay higher EMIs. A floating rate allows a borrowers to enjoy low interest rates; However, it does not shield them from unexpected interest rate increases. These loans can prove particularly challenging for households that have taken loan up to the maximum permitted limit in a market that is experiencing increase in interest rates. For example, an installation for an INR 2.5 million loan for a period of 20 years at 10% per annual results in a monthly installation or EMI of INR 24,126. The same installation goes up to INR 29,289 if interest rates increase to 13%. As the example indications, borrowers are often pushed into absorbing higher EMIs when rates increase, and when their income does not allow them to pay higher EMIs, they either default on the loan or are pushed to increase the term of their loan to keep it sustainable .
So, Fixed or floating rate?
When deciding between fixed and floating rate loan, one should consider the following factors. As all of us are different, each of these factors will play differently for us, and will impact our decision accordingly.
- Flexibility of your Monthly Income: If you are on a strict budget and can not afford any drastic changes, a fixed rate would be the best, as it will keep everything predictable. Although, it will be more expensive in the long run, but if you can not afford extra expenses, it will save you from making drastic changes to your life. However, if you have some flexibility in your budget and can manage with increase in rate of interest, the floating rate may work out to be better for you, as it is likely to be more economic than fixed rate, and then will result in better Return in the future.
- Loan Period: If you decide to take a loan for a longer term, a floating rate would be best as it allows for lower monthly repayments when the rates are low, and works out cheaper in long-run. A fixed rate for a longer time would mean much more money spent repaying the loan than is necessary. Also as mentioned above, as Indian economy matures interest rates are expected to lower, and so flexible rates are likely to work in favor of borrowers that are availing loans for 15 years period or more.
- Consider Current Rates: Evaluation of current market conditions and interest rate compared to last 5-10 years, can give one a sense of overall trend in the market. If current interest rates are lower compared average interest rates in the past, one can consider taking a fixed rate loan, since it will be fixed at the low rate for the period of the loan. A floating rate loan in a similar joke can work out to be more expensive in the long-run should the rates increase. Keeping a track of inflation and forecast by financial institutions on RBI action can also give a clue on the way interest would heading in the near future, and may assist in making a choice.
- Terms and Conditions: Similar to all financial products, careful scrutiny of terms and conditions is crucial to making the right decision. One should be aware that low rates offered during the initial period of loan is for the first few years, after which rates are reset at higher levels. Also, for some banks even fixed rate loans are not really fixed, and they may put in terms that allow them to change the rate if market rates increase drastically. This could defeat the purpose of fixed rate loan, and one could assume higher costs without being guaranteed a fixed rate. Make sure that the contract is clear and agreeable. Financial institutions also charge one time fees and processing fees during the start. Some banks are willing to reduce or waive-off these costs to win your business. It is pertinent that you evaluate and compare all costs, penalties and terms offered by different financial institutions. The interest rate offered by a financial institution or bank can vary from client to client, and is dependent on several factors such as credit history, sex, income level and relationship with bank. Also, rates offered by different financial institutions, with government banks generally offering loans at a better rate compared to privately-owned financial institutions. By approaching 3-4 financial institutions, one can quickly learn about different terms, fees and interest rates by them.
When choosing the best home loan product, look at all of the above factors to carefully evaluate, which option best suits your needs. Ensure that you read the fine print and fully understand terms and conditions. This helps to avoid any misunderstanding and frustration later. Investing in a property is a big decision for most of us, and careful scrutiny on all of the above points is essential.