When availing a home loan (mortgage), among the many decisions to make, the hardest is probably deciding the type of interest rate that you should choose. First let us learn about the different types of interest rates offered by the financial institutions:
Fixed rate of interest: In this case the rate of interest payable remains fixed throughout the loan period. But this kind of interest rates are comparatively bit higher (usually 1% – 2.5% higher) when compared to floating interest rate and only a few lenders offer this option.
Resettable fixed rates: Many lenders offer this variation of fixed rate of interest. Here the rate of interest is fixed for the period of 3 to 5 years; and after that period it gets reset once again for the next period.
Floating interest rates: It is also known as adjustable, flexible or variable rate of interest. Here the rate of interest fluctuates according to the market-lending rate. So the borrower should be ready to pay more EMI than the budgeted one if the lending rate goes up. As the borrower bears the risk of fluctuation, the rate of interest offered here is slightly cheaper as compared to the fixed interest rate. Therefore, if the interest rates are reduced (or even if it remains constant over the loan tenure) the borrower will gain. But if the rate of interest increases, then EMI will also increase, and thus the loan becomes expensive.
Partly fixed and Partly floating rate of interest: These loans are also referred to as fixed-cum-floating, fixed first, split rate and dual rate loans. Some lenders give the option to split the loan amount and charge fixed interest rate on one part and floating interest rate on the other. The borrower is given the option to decide the ratio (say half or quarter or three quarter) of the loan amount under fixed and floating interest rates. Some lenders even give the option to split the tenure of the loan, in which case the first two to three years they charge a fixed rate and then start charging the floating rate on interest. Some banks offer loans with significantly low fixed rates (also called teaser rates) for a short duration to lure in the borrowers. After this short duration, these loans convert into retail prime lending rate home loans.
Switching between the above interest rate options is also available with some lenders but that comes with an additional charge on the outstanding principal amount which can range between 0.5% – 2%.
Given the above, which type of interest rate should you choose for your home loan?
Advantages and Disadvantages of Fixed rate of interest loans: Fixed rate of interest is a better option if the current interest rates are below the average of historical interest rates in India (ex: average of loan rates over a 20-year period). Further, If you are not ready to face the risk of uncertainties and wants to play it safe, then it is better to opt for fixed rate of interest. Counting on salary increases that haven’t happened yet in order to afford what will probably be your largest monthly expense is risky. Fixed rates also mean that the borrower doesn’t benefit from falling rates. But, fixed interest rate is a less prevalent in India; even the so called “fixed rate of interest” comes with a resettable clause.
Banks generally offer fixed rate home loans only when the interest rates are very high and such offers dry up when the interest rates are low compared to historical interest rates. Even if they exist, the difference between fixed and floating rate loans is significantly high.
Banks generally charge 2-5% prepayment penalty on fixed rate loans because they carry the risk of interest rate changes.
Advantages and Disadvantages of Resettable Fixed rate of interest loans: Resettable fixed rate of interest gives more control and predictability to EMI amount when compared to floating interest rates. For example, if you plan to sell the home in the short term and the current rates are low, then this type of interest rate is advantageous to the borrower.
Advantages and Disadvantages of Floating rate of interest loans: To the borrower, it is better to opt for transparent floating rate of interest on home loan. Because, here the interest rate will increase / decrease along with the increase/decrease in the general interest rate. If the interest rates decline and the borrower continues to pay the same EMI amount, the loan tenure will get reduced. Also, floating rates tend to be lower when compared to fixed rates.On the other hand, if the interest rates increase, it can become a struggle to pay increasing month payments.
Studies conducted in other countries have shown that over long periods of time the odds favour the floating rate of interest. A transparent floating rate of interest means that the bank passes the burden (benefits) of increase (decrease) in general interest rate which will result in either the change of EMI or the change of loan tenure.
This situation is illustrated with an example below:
Suppose you take a home loan of 10,00,000 for 20 years with rate of interest of 9.5%, then your EMI comes to 9,321.
Let us say the rate of interest increases to 11.5% after 2 years. At this time, your outstanding principal amount would be 9,63,034 that is yet to be cleared in the remaining 18 years. You would have already paid 2,21,233 as interest by then.
In such situations, the bank will give you the option of A) adjusting the EMI upwards OR B) change the loan tenure so that EMI remains the same.
- In option A, your newly adjusted EMI will be 10,577.
- In option B, the remaining adjusted loan tenure will be a shocking 38 years and 3 months (excluding the 2 years already gone by). Don’t believe it? Use the EMI Calculator to check it out yourself. When loan tenure exceeds 20 years (with some banks 25 years), the bank may either ask you to go with option A or advise you to make a prepayment on the loan. This is because after certain point banks cannot increase the loan tenure to cope with the rise of interest rates.
One other advantage of floating rate loans is that banks generally wave off the prepayment penalty because the customer already carries the risk of interest rate changes.
Advantages and Disadvantages of Fixed-cum-floating rate of interest loans: Loans with partly fixed interest rate on one part and floating interest rate on the other offer interest-rate diversification. Diversification benefits borrowers just like it benefits investors who buy portfolios of stocks. However, such home loans are beneficial only when the interest rates are at a historical low (i.e., expected to rise in future) and not when they are peaking (i.e., expected to decline soon).
Here are a few questions you should ask yourself when deciding which type of interest rate you should choose:
- Are the current interest rates significantly low or high when compared to average of historical rates?
- Do you prefer predictable EMI payments?
- How long do you plan to live in the house? If you plan to sell, after how many years would you sell?
- Will your earnings increase or decrease or remain the same in the next few years? If you have a variable rate interest and the rate goes from 7% to 10% can you still afford it?
- Do you prefer a short or long term loan?
- What is the prepayment penalty if you want to switch to another lender who offers the type of interest rate that suits you later on?
Choosing between fixed vs. variable rate of interest is not about speculating whether interest rates will go up or down, it’s about risk management. Choose wisely and live frugally.
Calculate your loan interest rate.