Summary of this article
Fixed rates offer stability; floating rates offer flexibility
Interest rate cycles determine long-term loan costs
Borrower risk tolerance drives the best choice
One of the most important aspects in homebuying is selecting the right kind of home loan. The rate of interest and the tenure has a direct bearing on your finances and also dictates your future lifestyle.
Fixed and Floating Interest Loans
There are essentially two types of loans - fixed and floating interest loans. 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.
Here is what homebuyers should know and clarify about interest rates.
Difference Between Fixed and Floating Interest Rates
The fundamental difference between fixed and floating interest rates lies in how the interest rate behaves over time.
A fixed interest rate tends to remain unchanged for the entire duration of the loan. Since the rate is locked in, the borrower’s equated monthly instalments (EMIs) stay the same throughout the fixed period. The predictability allows borrowers to plan their finances with confidence and to be untouched by the market fluctuations in interest rates. However, most lenders hold the fixed-rate loans at a higher rate than the floating ones to compensate for the future.
A floating rate, on the other hand, moves along with the market conditions. It is mostly linked to an external benchmark set by the Reserve Bank of India (RBI).
When the market changes, the loan’s rate is reset to keep up with the market. As a result of this, the EMIs tend to increase or decrease. Floating rates offer flexibility to the buyer, as they can also benefit from falling interest rates.
Says Viren Mehta, founder and director, ElitePro Infra: “With a floating home loan, you will likely find that the rate begins 1-2.50 per cent lower, ultimately paying less with each term, provided the market rate declines. This will result in your EMI increasing or decreasing by a few hundred to several thousand rupees, depending on the amount borrowed and tenure.”
To clarify, fixed rates prioritise certainty and stability, while floating offers flexibility.
Which Option Has Cost Borrowers Less
Floating rates generally begin with lower interest rates than fixed rates because they do not include a long-term risk premium. Over longer periods of time, the advantage is combined with the ability to benefit from the rate cuts.
Adds Mehta: "Deciding between a fixed and a floating home loan basically depends on the amount of risk you are willing to take. Fixed home loans reassure you, as your EMI will remain constant, shielding you in case the interest rate shoots up abruptly.”
It is important to note that this outcome is not guaranteed. In a period characterised by gradual interest rate increases, borrowers who opted for floating rates may end up paying much more than those who had locked in a fixed rate. If the rates rise significantly soon after the loan disbursal and remain elevated for the majority of the years, the higher interest rates can become a burden for the borrower and can outweigh the initial savings.
Fixed-rate loans perform better in rising-rate environments, especially when borrowers can secure a fixed rate at or near the bottom of the interest rate cycle. In such cases, the premium paid for a fixed rate can be protected from higher market rates in the future.
“The best part about this scenario is that you now have the leverage to shift between fixed and floating home loans in the middle term, if the rates escalate," says Mehta.
