A fixed rate home loan in which the interest rate is pre-fixed for the tenure of the loan provides a known cash outflow for a known period. In a floating rate home loan, the interest rate changes on a quarterly basis as per market interest rates over the tenure of the loan.
Shikha, a 40-year-old mother of two, is an IT professional. She has been living with her parents since the demise of her husband five years ago. She feels that now is the right time to purchase her own home. She has approached lenders for a home loan and has to decide between a fixed rate loan and a floating rate loan. Which one should she opt for? This choice will not only affect her EMI outgo but also impact her repayment plan.
Shikha should know that predicting future interest rates is tougher than deciding how much of EMI she can pay comfortably. A fixed rate home loan in which the interest rate is pre-fixed for the tenure of the loan provides a known cash outflow for a known period. The risk to Shikha is that this might turn out to be a high rate that she locks into for a long period in the future.
In a floating rate home loan, the interest rate changes on a quarterly basis as per market interest rates over the tenure of the loan. She will be affected by the change in the base rate of interest indicated by the bank, which in turn is linked to market rates of interest and economic factors. Lenders typically adjust the tenure of the loan and keep the EMI constant in floating rate loans. If interest rates were to fall in the future, Shikha will benefit from a reduction in her repayment tenure. If rates move up instead, her repayment tenure can increase.
In both cases, it is the EMI that Shikha should first focus on, and be sure that she is able to pay it comfortably and is left with enough surplus for other needs. The key difference is that in a fixed rate loan, the bank bears the risk of future rates going up, while in a floating rate loan, Shikha bears the risk that the future rates could go up. Except for a lucky situation where Shikha is able to lock into a very low fixed rate, a floating rate loan is a better option as it does not try to guess the future rates.
Shikha should know that her bank may have a better view of interest rates than herself. A good clue may lie in the pricing. Fixed rate loans may be priced higher than floating rate loans, if the bank believes rates will rise. It helps banks to earn more as rates increase, through the floating rate option. If the fixed rate is priced lower than the floating rate, the bank is anticipating a fall in interest rates. It helps the bank to lock into a higher fixed rate. It is important to know whether the fixed rate home loan is fixed throughout the tenure of the loan or not as most lenders offer a loan which is fixed for initial 2-5 years and then it becomes floating.
(Content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)