When taking a home loan, the most important question is: Should I opt for a floating rate loan or a fixed rate loan?
Adjustable Rate Home Loans (or floating rate loans) are the ones in which the interest rates change throughout the duration of your home loan.
This means you will have no clue or information in advance as to how your rate will move. It could go up or down.
There are some things you should be aware of before (and after) opting for this product.
Before you opt for it
1. When will the interest rate change?
Your rate will change at a fixed period of time and this will be referred to as the Review Date.
This will be specified when you sign the loan contract. Typically, it happens every quarter -- once in three months.
Lenders like ICICI Bank have set review dates for all adjustable loans, like January 1, April 1, etc (the first day of every quarter, starting January).
HDFC has set it for every quarter from the date of your disbursement (the day you walked in and collected your cheque). Therefore, each loan has a different review date.
2. How will the interest rate change?
Your rate will be based on a base rate.
The home loan company will have a base rate. This is the lender's pre-selected, internal rate. The base rate changes due to changes in the interest rates in the economy. If interest rates in the economy rise, the base rate will rise. If interest rates in the economy fall, the base rate will drop.
This base rate typically varies from lender to lender, and so does their nomenclature.
HDFC calls it the RPLR -- Retail Prime Lending Rate.
ICICI Bank uses the term FRR -- Floating Rate Reference.
3. By how much will the interest rate change?
I explained earlied how the home finance company has a base rate and how this rate moves.
Now there will be a spread (or margin) on this base rate.
Let me explain.
A spread is the percentage added or subtracted from the base rate. This is meant to cover the lender's administrative and miscellaneous costs.
To the base rate, the home finance company will attach what is called a Spread.
Let's say HDFC's RPLR = 9.75%.
The interest rate offered to you = RPLR - 1% = 8.75%
It could also be = RPLR + 0.5%. = 10.25%
So you could either get it higher (premium) or lower (discount) than the base rate.
Depending on a host of factors (rates offered by other home loan players, how desperate the company is to get more customers, the current cash flow situation in the company and other monetary requirements) a home loan player will decide on the interest rate.
For instance, the home finance company may say that for a month, the interest rate will be 1% less than the base rate. After this scheme, it will switch to the base rate.
Or, if interest rates rise suddenly for a short period of time, then the rate may be 1% more than the base rate for that period only.
4. How will it affect me?
When you take a home loan with a floating rate, you have two options.
Option 1: The rate of interest increases or decreases, but you keep the tenure constant. In that case, the number of years you take to repay the loan stays constant but the EMI increases or decreases.
Option 2: When the rate of interest increases, you can extend the tenure. In that case, the number of years you take to repay the loan increases but the EMI stays constant. Similarly, when the rate of interest decreases, you can reduce the tenure of your loan.
After you opt for it
1. Keep tab of the EMI
Call up your bank at periodic intervals to check if there has been a change.
No doubt, the bank will intimidate you but if they don't, or their intimidation letter does not reach you, you will be expected to pay a higher EMI with no warning.
Get Ahead reader R S Sureka realised how important this was.
In January 2004, she took a home loan of Rs 11 lakh (Rs 1.1 million) from Standard Chartered Bank. It was a floating rate loan for 20 years at 7.49% per annum.
In June 2005, she called the bank to check out the interest rate being charged on her loan and was shocked when she realised it had increased six months ago. In December 2004, the rate was hiked from 7.49% to 7.99%. She had been blissfully unaware of it.
On calling the bank for an explanation, she was told they had sent a letter in November 2004, which she never got.
Lesson to be learnt: Find out the Review Date of your home loan interest. If you don't receive a letter from the housing loan soon after, call them and check the rate personally.
2. Check out the change of EMI and tenure options
If you want to change from an extended tenure to a change in EMI or vice versa, find out when it can be done and if you have to pay for it.
When the interest rate on Surekha's loan increased (see example above), she decided she needed to keep tabs on her home loan. She requested Standard Chartered Bank to increase her EMI instead of changing her tenure. This way, she would know the rate has increased automatically when the EMI increased.
They said that they could not do so immediately. The request would be considered only when there was another hike in the interest rate.
Since all these exchanges took place with the call centre staff, she finally met the manager in the call centre and asked for the contact details of a senior official in Standard Chartered Bank who could take a decision on this matter.
The manager said if she did go and meet someone in the bank, the query would once again be forwarded to the call centre. Moreover, the senior officials are Mumbai-based (she is Chennai-based).
When Get Ahead contacted the bank, we were told that, in general, banks usually increase the tenure of the loan; they said this was beneficial to the customer as he need not issue any fresh repayment instructions.
"If", they continued, "the customer wishes to increase his EMI, he can do so provided he is eligible to pay the higher EMI."
Lesson to be learnt: At the start, find out if you can switch from fixed EMI/ variable tenure to variable EMI/ fixed tenure and vice versa.
3. Be prepared for a higher interest rate
When Get Ahead reader Sushama Desai took a home loan from IDBI Bank -- she had opted to keep the EMI constant and increase the tenure of her loan instead -- the interest rate was 7.25%. Over time, it rose to 8%.
This change in the interest rate resulted in her loan tenure being increased by 40 months -- more than three years! This is a very serious consideration you must look into.
Though interest rates will fall in the long-term, they seem slated to rise in the immediate future.
Are you financially in a position to pay a higher EMI? If not, are you comfortable with the thought that the tenure of your home loan might be extended?
Lesson to be learnt: See if you can financially provide for a variable loan. Try different scenarios: increased EMI, increased tenure.
4. Check out the switch between fixed and floating options
Sushama decided to opt for the fixed rate loan when she realised she was not comfortable with the floating rate package.
When she informed IDBI Bank, she was told she would have to pay a fee to do so -- the fee was 1.5% of the remaining principal amount. At that time, it amounted to 1.5% of Rs 10 lakh (Rs 1 million), Rs 15,000.
In addition, she was told the shift would be valid only for three years; then, she would again be charged the floating rate.
When Get Ahead spoke to IDBI Bank, we were told the bank does not encourage fixed rate loans and offers them only for a fixed period.
Lesson to be learnt: A few home finance companies offer a fixed rate of interest at the start and then switch to floating. Or even vice versa. Ask the home financier if they have any restrictions on the change. And if they have any conversion fees levied too.
Note: The examples mentioned here have been emailed to us by Get Ahead readers. They are not in any way endorsed by rediff.com.
Illustration: Dominic Xavier