Floating Rate vs Fixed Rate Loans

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Once we start earning money in our life; we start dreaming of our own home or a high end car, which leads to the thoughts of availing loans from Banks/NBFC.  Though getting a home loan or a car loan is getting easier but every prospective borrower has to face with one common question i.e. whether to avail a fixed rate loan or a floating rate loan.

This article is intended to help you while deciding upon the type of loan; let us start with understanding of Fixed Rate /Floating Rate Loan. Article will end with basics of pre-payment charges.

Fixed Rate Loan: Fixed rate loans means borrowed money will be paid back in equal monthly installments through the term of the loan. As the name suggests, fixed interest rate loans are not affected by market fluctuations. Borrowers; who are very particular about budgeting and prefer to plan out their repayment schedule with a fixed monthly amount, this type of interest rate should interest them more as it gives a sense of certainty.  So there is a reasonable measure of predictability to loan tenure, EMI commitments and the total interest outflow.

Benefits of Fixed Rate Loans:

  1. Fixed interest rate remains constant for the entire loan tenure. This rate of interest doesn’t vary according to the rise and fall in the market.
  2. Since interest rate doesn’t fluctuate over time, loan has to be paid back in fixed monthly installment throughout the tenure. Therefore, borrower can accurately plan finances under this type of loans.
  3. If economic conditions indicate that there are chances of a rise in the interest rates in future, fixed interest rate loan is best option that a borrower should choose in order to ensure that he or she can continue to pay a smaller amount as interest.

Drawbacks of Fixed Rate Loans:

  1. The fixed interest rate is usually 1% to 2.5% higher than the floating interest rate offered by a bank or non-banking financing company (NBFC).
  2. If federal bank like RBI in India decides to lower the rate of interest for home loans; borrowers who opt for fixed rate loans do not get benefit of such opportunities.
  3. Banks/HFC charges prepayment fee in case of fixed rate loans.

When to Opt for Fixed Rate Loans:

  1. In case borrower is comfortable with EMI.
  2. If borrower expects interest rate for home loans to go up in future then opt for fixed rate loans.
  3. In case; interest rate for home loans have come down than usual due to a certain policy of central bank then it is advisable to lock fixed interest rate.

Floating Rate Loan: Floating interest rates are linked to market interest rate and varies with market scenario or macro-economic conditions or monetary policy of central banks. Opting for floating rate loans means borrower is subjected to a base rate plus a floating rate element; which means if base rate will vary so does the floating element.  In other words floating rate loans are linked to the lender’s benchmark rate; which in turn, moves in sync with the market interest rate. If there is a change in the benchmark rate, the interest rate on the loan also changes proportionately.

The interest rate on such loans is reset at specified intervals. It could be calendar periods like every quarter or half of a financial year or it could be unique to each customer depending upon the date of first disbursement of his home loan. Alternately, the reset could also be linked to loan anniversary. If there has been a change in the market rates during the review period, interest rates too would be reset higher or lower as the case may be. In cases of such rate resets, it is usually the tenure of the loan that gets re-adjusted to account for the changed interest rate. If the rate increases, remaining loan tenure would be extended and vice-versa. This is done to avoid frequent revisions to EMI which could impact family’s cash flow. But if borrower desires, borrower may request the lender to revise EMI instead of the loan tenure.

Benefits of Floating Interest Rate

  1. Floating interest rates loans are usually offered at lower rate than the fixed rates.
  2. Even if floating interest rate exceeds the fixed interest rate, it will not be for the entire loan tenure. There are chances that the floating rates might come down after a certain period of time.
  3. Banks/HFC are not allowed to charge prepayment fee in case of floating rate loans.

Drawback of Floating Interest Rate:

  1. Monthly installments for floating rate loan will vary through the term of the loan and budgeting might be problematic for households.
  2. Floating interest rate loans could cost more in case central bank decides to increase the home loans.

When to opt for Floating Interest Rate:

  1. If borrower expects interest rate to go down in future.
  2. If borrowers are looking for some savings on their interest cost in the near term, floating rate loans are usually set at a marginally lower rate than fixed rate loans thereby giving some benefit in terms of cost of loan.

Pre-Payment Charges:  Prepayment penalty is a fee or charge that borrower has to pay to the bank, if borrower decides to repay a loan before the end of its term. Borrower may decide to prepay the loan from his own savings or by transferring loan to another bank to get lower interest rates.

Why do lenders charge Prepayment Fees on Home Loan?

It may sound absurd, that incase borrower decides to repay loan early then borrower has to pay a penalty on making loan repayments before time. Lenders charge fees on early repayment of loans because some loans are designed to last a certain number of years and earn interest for bank for that tenure such as a 30-year home loan. If borrower decides to close the loan before that certain time period, the bank may have to bear a loss especially if the loan is a fixed rate loan and interest rates are declining at the time of loan pre-closure. Banks charge prepayment penalty to safeguard themselves from any potential loss in a situation of loan prepayment during the loan tenure and also, to deter a customer from transferring their loan to another bank.

Conclusion:

  • Floating rate loans are popular due to the flexibility which they offer to the customers.
  • If borrower is certain about interest rates rising in the future and would like to lock in loan at the existing rate, opt for a fixed rate loan.
  • Anytime during the tenure of loan, borrower can convert fixed rate loans into a floating rate loan and vice versa, by paying a small fee.
  • There are no prepayment penalties in a floating rate loan.
  • One’s choice of fixed, floating or combination loan depends on one’s personal situation, needs and level of understanding of interest rate movements.
FIXED FLOATING
Interest rate on the loan remains fixed throughout the loan tenure. Interest rate on the loan changes based on change in the lender’s benchmark rate.
Fixed rates are slightly higher than floating rates. Floating rates are slightly lower than fixed rates.
If you are comfortable with the prevailing interest rates, are reasonably sure that interest rates will rise in future, opt for a fixed rate home loan. If you are unsure about where interest rates are heading, opt for a floating rate home loan.
There is a prepayment penalty in case of fixed rate home loans. There is no prepayment penalty in case of floating rate home loans.

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