The Cheapest Home Loan May Not Be the Best: What Borrowers Should Check

Whenever an individual opts for a loan, they typically focus on the rate of interest offered on the loan. A lower rate of interest can mean a cheaper loan. However, the headline rate does not always tell the full story of downsides or clauses. The loan’s tenure, reset frequency, fees, repayment structure and, importantly, how rates may change over time can affect the total cost.

Rate Cycles Matter More Than Today’s Rates

A loan should be evaluated across the entire tenure rather than on the rate available on the day it is sanctioned. This is especially important for long-term loans, such as home loans, where borrowers may remain exposed to interest rate movements over the loan duration. Floating rate loans can become more and more expensive when interest rates increase, even if the initial rate is attractive. Conversely, borrowers can benefit when rates decline.

Understanding the interest rate cycle and the loan’s reset mechanism is crucial.

Says Nakul Saxena, business head, housing finance, Kotak Mahindra Bank: “Every borrower must keep in mind that an interest rate is not merely a number set by a bank; it is influenced by the broader economic environment, and in the case of policy rates, by a central bank’s assessment of inflation, economic growth, liquidity, and other monetary conditions.”

He adds, “For instance, at a repo rate of 5.25 per cent, home loans are being disbursed at around 7.25–7.75 per cent on average. For a loan of Rs 50 lakh taken for a period of 20 years, every 0.50 per cent increase in interest rates can add roughly Rs 1,500-2,000 to the equated monthly instalment (EMI). This additional amount must invariably come from a household’s already-depleted savings pool, particularly during the first five years.”

Borrowers should check how frequently the lender resets the interest rates, which benchmark the loan is linked to, and how quickly changes in the benchmark are passed on. A slightly higher initial rate may sometimes be worthwhile if the loan offers greater transparency or favourable terms.

Adds Saxena: “This practically means that the cheapest loan today need not be the safest or most comfortable one for you over the next 10 years. Hence, gauging the resilience of the EMI, particularly during the first 5-6 years is vital to sustainable debt servicing.”

Floating vs Fixed Rates

Floating and fixed-rate loans involve different risks. With a floating-rate loan, the borrower accepts uncertainty in exchange for the possibility of benefiting when rates fall. Rising rates can increase the financial burden or extend the repayment period.

There are essentially two types of loans: fixed and floating interest rates. The choice between a fixed and a floating rate loan not only affects the monthly payments, but also the total interest paid over the entire tenure of the loan. While lenders and advisors promote one option over the other depending on the market conditions, the better choice is highly subjective.

The right choice depends on a borrower’s income stability, loan tenure, and ability to absorb fluctuations in higher EMIs. There is no one-size-fits-all option in this.

Says Saxena: “Banks link their floating-rate loans to an external benchmark, such as the Reserve Bank of India (RBI) repo rate or specified Treasury-bill rates, and these loans are reset at least once every three months. That also means every rate cut does not necessarily benefit your EMI instantly; the speed and extent of transmission depend heavily on the benchmark and the terms of the loan. A higher inflation scenario, tighter liquidity, or other economic pressures can lead to tighter monetary policy and higher benchmark rates, resulting in higher EMIs, a longer repayment period, or both, depending on the loan structure.”

The Value Of Predictability

For long-term loans, such as home loans, predictability also has a financial value, which is often overlooked. Knowing that an EMI will remain stable can make household budgeting easier, especially for buyers with limited monthly surpluses or irregular incomes.

Adds Saxena: “As part of the basic analysis, a borrower must understand how the lending rate is determined and how frequently it is reset by the lender. It is also important to understand the lender’s benchmark and spread to assess the speed and extent of transmission when rates change.”

A useful approach is to ask three questions: What will this loan cost if the rate rises? What happens if rates fall? And can the individual comfortably manage the EMI under either scenario?