Home loan interest rates have been moving down over the last couple of years. At some point in time, the interest rates will bottom out. Some of us may feel that the interest rates have already bottomed out. In that case, if you are planning to take a home loan, is it a good idea to take a fixed interest rate (instead of a floating rate interest loan)?
With a fixed interest rate, you can lock-in the interest rate for the loan tenure. Subsequent hikes in interest rates will not affect your loan interest rate. I have compared the fixed and floating rate loans earlier in this post. However, I thought of discussing this aspect again due to the current interest rate scenario.
HDFC Home Loans
Let us first look at the fixed and floating interest rates from HDFC for a home loan amount of Rs 30 – 75 lakhs.
Floating interest rate: 7.25% to 7.75% p.a. (Standard Home Loan)
Fixed interest rate: 7.6% to 8.1% p.a. (TruFixed Loan — 2-year Fixed Rate Variant)
So, the fixed interest rate is 0.35% p.a. higher than the floating rate.
Why Should Fixed Interest Rate Be Higher Than Floating Interest Rate?
Because the bank/NBFC is taking a higher risk. They are lending you for a long term at a fixed rate and thus bearing the interest rate risk. What if they lend you at 8% p.a. fixed rate? Interest rates rise over the next few years and the prevailing interest rates range around 10-11% p.a. Were your home loan on a floating interest rate, the loan interest rate would go up with prevailing interest rates. However, since you have a fixed rate loan, you will still pay 8% p.a.
However, there is a caveat here. The banks may not be taking so much risk. We shall discuss this later in this post.
Fixed Rate Loans Can Have Prepayment Penalties
RBI does not permit any prepayment penalty only for floating rate loans. Your bank can still charge you prepayment penalty for a fixed interest rate loan.
Pre-payment penalty adds friction if you want to prepay your home loan or if you want to switch out to another lender.
We prefer to close our loans soon. We (Indians) tend to prepay our home loans in 7-9 years. This means there is a tendency to make partial prepayments on a regular basis. In a fixed rate loan, this may attract penalty. That is a drawback for anyone who intends to close the loan much before the original tenure ends.
By the way, from the perspective of the banks, this is NOT an unfair cost. Or else borrowers will continue with fixed rate loans if the rates are rising OR refinance their home loans (take a balance transfer) at lower rates if the interest rates fall. While the banks cannot stop borrowers from refinancing their home loans, a prepayment penalty imposes a cost and creates disincentive.
HDFC charges a prepayment penalty of 2% of the prepayment amount if you are prepaying (or part-prepaying) the amount through refinance from bank/NBFC etc (and not from own funds).
- Conversion charges from Fixed to Floating: 1.75% of the outstanding + undisbursed amount.
- Conversion charges from Floating to Fixed: 0.5% of the outstanding + undisbursed amount
We Do Not Really Have Fixed Rate Loans
With HDFC Fixed Rate loan, the interest rate is locked in for only 2 years. Thereafter, the bank can reset the interest rate. So, the fixed rate becomes floating after the initial period. You are not really getting a fixed rate loan. The “fixed interest rate” is only for a few years. After that, it becomes floating too.
The risk to the bank is also lower since they know they can reset the interest rate after a few years. Because of this, the differential between the fixed rate and floating interest rate can be lower since the bank is taking the risk only for a few years and not the entire tenure. It is possible that, without the reset clause, the difference between the fixed and floating interest rates may have been 3% p.a. and not 0.35% p.a.
By the way, in case of floating rate loans, the interest rate calculation is quite transparent. There is a benchmark (RLLR or any external benchmark), and you pay a spread over the benchmark. The spread remains constant during the loan tenure (unless there is a change in your credit profile). As the benchmark goes up or down, your home loan interest rate will move up and down. Simple. Earlier with internal benchmarks such as base rate or MCLR, you could have argued that benchmark calculation was non-transparent. However, new floating rate loans must now be linked to external benchmarks such as the RBI Repo rate or treasury yields. And the banks have no control over external benchmarks.
What Should You Do?
I tried to explore fixed rate loan options on websites of many banks and NBFCs, but there was not much information available. Couldn’t find a loan product that was at fixed rate for the entire tenure.
While a fixed rate loan offers certainty, I would prefer a floating interest rate over a fixed-interest rate home loan for the following 3 reasons:
- Fixed rate loans are not really “fixed rate” for the entire tenure. You lock-in the interest rate only for a few years.
- You pay a higher interest rate on a fixed rate loan.
- Given our propensity to prepay home loans soon, the prepayment penalty on fixed rate loans imposes friction.