Home loans are long tenure loans. 15-30 years. And even a difference of a few basis points can make a huge difference to your overall nominal outgo.
Assuming the interest rates stay constant, here is the difference between the cash outgo to repay a Rs 50 lacs home loan in 20 years.
|Total Payment over the loan term|
My assumption above is that the interest rates stay constant. Well, this is hardly ever the case.
And it starts to pinch you when the interest rates are rising. As the interest rates rise, either your EMI or the home loan tenure must go up (unless you decide to prepay your home loan partly). Either way, your total outgo goes up in case of an interest rate hike.
Do you know you could have avoided this problem? By opting for a fixed rate home loan. In the example above, we considered a floating rate home loan, where the loan interest rate changes with the change in benchmark rate. Had your home loan been a fixed rate one, you wouldn’t have to worry about the change in interest rates.
But and there are always buts.
Two Types of Fixed Rate Home Loans
I reproduce the fixed rate home loan from ICICI Bank website. The bank is currently offering floating interest rate home loans at 9.0% p.a. to borrowers with credit score above 750.
As you can see, there are 2 types of fixed rate loans. The first where the interest rate is fixed only for a certain number of months. In this case 24, 37, 60, and 120 months.
Up to 60 months, the fixed rate is almost the same as the floating rate. However, for longer duration “fixed rate”, the difference widens.
The fixed rate for “120 months fixed” and the “full term fixed” is much higher than the prevailing floating interest rate. About 2-3% higher.
In the second, the interest rate is fixed for the entire tenure.
These are the quotes from Axis Bank website.
As we can notice, there is not much difference between floating rates between the two banks but the difference between fixed rates is over 2%.
Note: The difference between the floating and fixed interest may vary depending on the outlook of the bank about interest rates. I have reproduced rates from just a couple of banks. Other banks may offer widely different fixed interest rates.
Why Are We Discussing This Topic Again?
I have written about Floating vs Fixed rate home loans before. I discussed the merits and the demerits of both the options in the post. If you believe that the interest rates are going to jump sharply, you are better off locking in your rate of interest for the next few years (and not the entire tenure). Otherwise, a floating rate home loan is a better choice.
So, why are we discussing this topic again?
As I understand, most banks don’t offer fixed rate home loan products. Now, with the regulator mandating an option, you can expect fixed rate home loan products from the banks. Expect competition to heat up in this space.
Whether those loan products are fixed rate for a limited period or for the entire tenure, we will have to see. RBI has not mandated that the “fixed rate” should be for the entire tenure. The banks have discretion there.
Plus, your bank may charge you a fee on switching from your home loan. floating to a fixed rate. The Reserve Bank does not put a cap on such charges. But I believe competition will take care of such charges and even the difference between the fixed rates across the banks (as we saw between Axis Bank and ICICI Bank).
Additionally, the RBI has specifically asked the banks to communicate these options to the customers. I hope the banks don’t cut corners here and you get proper information about the choices available to you.
Now with choices staring in your face, you must decide. Whether to increase EMI, increase tenure, or switch to fixed rate loan. Deciding is not always easy.
When the interest rates are rising, you may find fixed rate home loans attractive. However, you also want to make sure that you do not lock-in too high a rate.
What Are the Factors That You Must Consider Choosing between Fixed and Floating Rate?
Go for a fixed rate when the interest rates are expected to go up.
Go for floating when the interest rates are expected to go down.
Sounds good but it is not easy to get interest rate movements right. In that case, what do you do?
Fixed rate home loans are a double edged sword. You benefit if the interest rates go up after you take the loan. You lose out if the interest rates go down after you take the fixed rate loan. Yes, in that case (interest rates going down), the bank may offer you an option to switch to a floating rate loan but that will come at a cost.
Here are a few points that you must consider.
- What is the premium for a fixed rate home loan? Since the bank takes a risk by locking in your rate of interest for a few years, the interest rate of fixed rate home loans is usually higher at the start.
- How fixed is a Fixed rate home loan? Most fixed rate home loans are only fixed for a certain number of years. Therefore, the loan automatically becomes floating.
- How soon do you plan to close the loan? The sooner you plan to close the loan, the impact of interest rate on the absolute outgo also goes down. This is an important aspect. That of home borrower tendency to pay off the home loans earlier than the contracted schedule. In about 7-10 years. If the home loan is closed much sooner than the contracted schedule, the nominal impact of interest rates also goes down.
Is There a Merit in a Fixed Rate Home Loan?
Let’s consider the example of Axis Bank that offers Fixed rate home loan at 14% p.a. I assume this interest rate is fixed for the entire tenure. Floating rate is 9-9.4% p.a. It is possible that the data on Axis Bank website is dated but would you pay a premium of 5% p.a. just to lock in your interest rate for the entire duration.
We can go back and look at the historical home loan interest rates as well. I checked the data for historical home loan interest rates from SBI website. This has data from 1994 until 2015. After 2015, I don’t think the home loan interest rates have ever touched 14%.
Hence, since the turn of the century, the SBI home interest rate (for new loans) has never been as high as 14% p.a. Yes, the future may be starkly different from the past but when the data tells us that the floating rate interest hasn’t touched 14% over the last 20 years, the case for locking in a high rate of interest through a fixed rate home loan becomes quite weak.
I understand ICICI Bank fixed rate offering is much cheaper. At about 11.45% p.a. This is still 2-2.5% higher than the current floating rate interest. Not sure if I would want to take that bet.
At the same time, there is no one-size-fits-all solution here. You may still see merit in fixing interest rates for a few years (and not for the entire term) if you expect interest rates to go up sharply in the near term. With the gift of hindsight, it would have been a good idea to lock in a fixed interest rate for a few years in mid-2021. I assume the difference between the fixed and floating was not too wide at the time.
While it is not easy to predict interest rate movements, I see nothing wrong in acting based on your outlook. But yes, the premium (fixed-floating) interest rate should not be too high.
Going by the fixed interest rates from ICICI Bank, the fixed interest rate for up to 60 months is not too different from the prevailing floating interest rate. Such offers may be acceptable.
The Prepayment Problem
Is there a merit in paying a premium of say 2-5% p.a. when you plan to close the loan in say 5-7 years?
Home loan borrowers prefer to expedite loan repayment. And you expedite by making prepayments.
Fixed rate loans present two problems here.
Firstly, the banks are allowed to charge prepayment penalty for fixed rate loans. They can’t charge prepayment penalty for floating rate loans. So, if you are planning to prepay your home soon, by opting for a fixed rate loan, you are not only paying a higher interest but also a penalty for every prepayment. ICICI Bank charges 2% of prepayment amount as penalty.
Secondly, if you are anyways planning to close your home loan soon, you may not want to pay a heavy premium (fixed-floating) for a fixed rate loan. What’s the point after all? For the fixed rate loan choice to look good, the interest rate would have to move up sharply and quickly. However, if the premium is not too high, a fixed rate loan may still make sense since you won’t have to worry about interest rate movements.
What do you prefer: Fixed rate or floating rate home loan?