You have finalised your dream house to purchase. You have also finalised the bank to take home loan from. You have a long relationship with the bank. You have been informally told that you will get the loan easily given your high repayment ability. You are planning to visit the bank branch tomorrow. The spirits are high and the excitement pertaining to purchasing your dream house is palpable. However, you are still facing a dilemma. You are not sure if you should go for a fixed rate or a floating rate loan.
Must Read: Fixed Rate Vs. Floating / Variable Interest Rate – make the right choice
What are Floating Rate Loans?
Under floating loans, the home loan is offered at a sum of Benchmark + Spread. All the floating rate loans offered after March 31, 2016 are linked to Marginal Cost of Lending Rate (MCLR). The spread depends on multiple factors including your repayment ability. The benchmark rate (MCLR) can be revised regularly by the bank. Technically, even spread can be revised but banks typically don’t do that.
Consider home loan interest rates from ICICI Bank. Currently, ICICI Bank is offering home loans up to Rs 5 crores to salaried employees at 1-year MCLR + Spread of 30 bps. 1-year MCLR is 9.15% at present. Hence, you can get loan at 9.45%. Subsequently, if the 1-year MCLR is revised subsequently to say 9.3%, the effective interest rate will go up to 9.6% p.a. MCLR linked floating rate loans have an interest reset clause. So, the effective rate of interest will be modified for you only on interest reset dates. Hence, your effective interest rate may not get modified for sometime even if the underlying benchmark has been revised.
What are Fixed Rate Loans?
As the name suggests, the interest rate is fixed for the entire period of the loan. There are some variants of fixed rate loans though. Under some plans, the interest rate is fixed for a few years and the loan becomes a floating rate loan subsequently.
Let’s look at options from ICICI Bank (for male salaried employees).
| Floating Interest Rate | ||
| Category | Effective Rate | Rate |
| Up to Rs 5 crores | 9.45% | 1-year MCLR + 0.30% |
| Above Rs 5 crores | 9.70% | 1-year MCLR + 0.55% |
| Fixed Interest Rate for 2-3 years | ||
| Category | Fixed rate for 24/36 months | Floating rate from 25th month/37th month |
| Up to Rs 5 crores | 9.45% | 1-year MCLR + 0.30% |
| Above Rs 5 crores | 9.70% | 1-year MCLR + 0.55% |
| Fixed Interest Rate for 4-5 years | ||
| Category | Fixed rate for 60/120 months | Floating rate from 61st month/121st month |
| Up to Rs 30 lacs | 9.45% | 1-year MCLR + 0.30% |
| Above Rs 30 lacs | 9.55% to 9.80% | 1-year MCLR + 0.55% |
| Fixed Interest Rate for the Entire Term | ||
| Category | Effective Rate of Interest | |
| Up to Rs 30 lacs | 9.75% | |
| Above Rs 30 lacs | 9.85% to 10.10% | |
In the rest of the post, I will consider loans where the interest rates are fixed for the entire loan.
Benefits of Fixed Rate Loans over Floating Rate Loans
- Interest rate remains fixed for the duration of your loan.
- You are not bothered even if the interest rates are rising.
- You know your EMI for the entire duration and you can budget.
Drawbacks of Fixed Rate Loans
- The rate of interest in a fixed rate loan is certainly higher than interest in floating rate loan. For instance, currently, ICICI Bank is offering Rs 50 lacs floating rate loan at 9.45%. The interest rate for fixed rate loan ranges between 9.85% and 10.1% per annum.
- Banks may not be comfortable offering you a larger loan amount under a fixed rate loan.
- You stand to lose out when the interest rates are going down. You will still pay a high fixed rate of interest.
- With fixed rate loans, there might be a penalty on pre-payment. RBI and National Housing Bank prohibit prepayment penalty for floating rate loans. There is no such restriction for fixed rate loans. For instance, ICICI Bank charges 2% of outstanding principal. Both part prepayment and full prepayment can be very expensive.
What Should You Do?
Fixed rate loans might sound like a good idea to those who prefer certainty. It might also be beneficial from budgeting perspective. For instance, if you are using rent from first property to pay EMIs of a second property, a fixed rate loan may set up a well oiled machinery. You use the rent to repay home loan. Since housing loan is a fixed rate loan, you don’t have to worry much. The assumption is that the rent won’t go down.
However, in my opinion, the negatives far outweigh the benefits of fixed rate loans.
The penalty on prepayment is a big negative in case of fixed rate loans. It affects your ability to deploy excess cash (say through annual bonus) to decrease your loan liability. We have seen how part-prepaying home loan at regular intervals can reduce your interest liability.
Another point to note is that you are starting with a higher interest rate in case of a fixed rate loan. So, you will pay a lower EMI to begin with under a floating rate home loan. You can always use EMI savings under a floating rate loan to part-prepay the loan. There is no penalty for prepayment in case of floating rates.
I am not an expert on interest rate movements and can’t comment on direction of interest rate movements. A home loan is a long term commitment. Interest rates will move up and down. The interest rate on floating rate loan may move above the fixed rate after a few years and may move back below the fixed rate later. I don’t know how interest rates will pan out. It is quite possible that interest rates will move upwards after you take a floating rate loan and stay there for prolonged period. In such a case, you might end up regretting your decision to take a floating rate loan (instead of a fixed rate loan). Well, the opposite may also happen. The interest rate may go down further from here and not move back above fixed rate anytime soon. You can never know this upfront. Therefore, for the sheer flexibility that a floating rate loan offers, my vote goes to floating rate home loans.