Owning a home often involves a home loan and these are big ticket, long-term commitments. As the loan involves lakhs of rupees and runs up to long terms like 20-30 years, interest paid on these loans matters a lot. Often, individuals pay an amount equal to or more than the principal of the loan as interest. Let’s look at an example to demonstrate the same.
A loan of Rs 50 lakhs is availed at an interest of 8.75% for 20 years. Let us consider that the interest over the tenure of the loan remains same. The EMI works out to be Rs 44,186.
Over the period of 20 years, the total amount paid by EMI comes up to Rs 1,06,04,528. So, you end up paying an interest of Rs 56,04,528 for a principal amount of Rs 50,00,000, which is more than the principal amount itself. If you increase the tenure by another 5 years and you pay Rs 73,00,000 in interest.
So, even though you may think that the EMI is affordable to you, an enormous amount of money is paid just as interest on your home loan.
Rate of Interest Matters
The important factor that determines how much you pay in form of interest is obviously the rate of interest, the other determinant being the tenure. So, it becomes important to bag a favorable rate of interest from the bank. A favorable rate of interest is again a function of many different components like your credit score, repayment ability and the bank's policies on lending.
The Dilemma Between Floating and Fixed Rate?
Let us assume that you have a great credit score and get ticks on all other requirements needed to get a favorable rate of interest. And you are in agreement with your bank/financial institution over all other terms and conditions associated with the loan.
Now the bank gives you the option of choosing between floating and fixed rate of interest. How do you go about choosing one over the other? Which one of the two would be good for you over the term of the loan? Will you pay more interest on a floating interest rate or a fixed interest rate? These are some of the questions that every home loan borrower faces while borrowing a loan.
We bring you the differences between a fixed rate and a variable or floating rate home loan and when you should opt for one over the other.
Fixed Rate Home Loan
As the name suggests, a fixed rate home loan means your loan is linked to a fixed rate of interest which is pre-decided at the time of availing the loan.
Among fixed rate loans, there are two variations: one that is fixed for the entire tenure of the loan and the other which is fixed for a certain tenure of the loan; say for 3 years, 5 years or 10 years; post which the loan is based on prevailing floating rates.
Fixed rate loans do not offer free prepayment of the loan.
Ex: ICICI Bank offers a fixed rate for 2, 3, 5, and 10 years post which the loan is linked to a floating rate. On the other hand, Axis Bank offers a fixed full 20 years terms at a single rate of interest
When Should You Go in For A Fixed Rate Home Loan?
When you avail a fixed rate home loan, the interest amount is fixed and so is the EMI amount. This benefits the borrower in more than one way. Some of the reasons when a fixed rate loan proves better are:
Helps you better plan your EMIs: As you are aware of the EMI amount well in advance, you can plan not only for the EMIs in the near future but through the entire term of the loan. This helps you in doing a better financial management over long periods of time.
Once the EMI for one of your loan is fixed, it becomes quite easy for an individual to plan credit or avail loans for any other requirement.
Fixed Rate Home Loan Helps Those Who Like Stability: With a floating rate loan, there is uncertainty over the movement of interest rates, which might call for changes in your financial planning. Some individuals prefer stability and would like to avoid risks. For all those individuals, a fixed rate loan looks like a better proposition than a floating rate home loan.
If You Foresee A Trend Of Increasing Interest Rates: Based on the current economic conditions, if you foresee a trend of rising interest rates, then going in for a fixed rate loan makes more sense as you can get your EMI locked at a fixed rate and avoid paying higher EMIs.
Are Fixed Rate Home Loans Expensive Than Floating Rate Ones?
There seems to be some benefits of going in for a fixed rate housing loan. However, the question that has everybody wondering is if fixed rates more expensive than the floating ones?
When you compare with the floating rate currently prevalent, the fixed rate loan is fixed at a higher level.
For Ex: The floating rate for a home loan at a certain bank for loan amount between Rs 30-Rs 75 lakhs would be priced at 9.25% while the full tenure fixed rate for loan above Rs 30 lakh would be priced at 10.05%-10.3%.
So, as you see, the interest rate of a fixed rate loan would be priced higher than the prevailing interest rate of a floating rate loan. Although, you have to keep in mind that the interest rate of a floating rate loan could very well increase in the future, and might get higher than that of a fixed rate loan.
Floating Rate Home Loan
Floating Rate Home Loans are those home loans which are based on a benchmark rate that varies depending on the present economic scenario. The banks normally charge a spread or a markup over the benchmark to arrive at the floating rate.
The benchmark that the banks currently use for the pricing of loans is Marginal Cost of Fund Based Lending Rate (MCLR). The banks are supposed to arrive at this rate after taking into account their cost of raising funds. And each bank is mandated to publish this rate at pre-determined intervals.
These benchmarks are reset at pre-fixed intervals like 6months, 1 year, etc. Whenever there is a reset, the effective rate of interest either increases or decreases. As the rate of interest moves up or down, so should your EMI.
But increasing or decreasing EMI proves to be difficult as the banks generally prefer to auto-debit the amount from the borrower' s bank account. These are fixed instructions that require them to redo the paperwork each time. It is also difficult for the borrower to repeatedly make changes and disturb his/her budget.
To avoid all these situations, the banks adjust the tenure of the loan to reflect the change in the rate of interest. When the rate of interest increases, they increase your tenure and vice versa when there is a drop in the interest rate.
When Should You Go in For a Floating Rate Loan?
When you are looking at paying lower EMIs: As we have mentioned above, the rate of interest on a fixed rate loan is higher than the prevailing interest rate on a floating rate loan. If you are looking at lower EMIs at least to start with, then floating rate loan is the one you should choose.
When You Foresee A Dropping Interest Rate Trend: If you are able to notice a falling interest trend in the months/years to come, then a floating rate loan makes more sense and will save you some money.
If You Can Take Interest Rate Fluctuations in Your Stride: Floating interest rate loan is bound to see some ups and down in the interest rate over the tenure of the housing loan. One should be ready to bear the fluctuations and not get worried by them. If you are such a kind of person, then the floating rate home loan is for you.
Does Variable Interest Rate on Home Loans Work Out Cheaper for You?
It is extremely difficult to predict how an interest rate cycle will span out during the term of your loan. When you look at the interest rates (RBI Repo Rate considered as a benchmark) between 2001-2018, the lowest interest rate has been 4.25% and the highest at 14.5% and the current benchmark stands at 6.5%.
Therefore, it is not possible to say if the variable/floating interest rate works out cheaper for you. However, it is the most popular one among the borrowers due to the flexibility it allows. There is no prepayment penalty on floating rate loan.
For many of you, it may still be difficult to make a decision to go with fixed or floating rate loans. For those, we suggest the partly fixed and partly floating rate. Go in for loans that have a fixed rate for a certain number of years post which the floating rate applies.
The choice between floating and fixed should be decided based on your need, repayment capability, financial planning and your views on the interest rate cycle. And whichever kind of loan you go in for, make sure your EMI repayment is on schedule.