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I took a floating interest rate home loan from ICICI Bank.
As you are aware, the interest rate increased by 1% over the last year. Consequently, my interest has gone up to 8.5% from 7.5% per annum.
I was thinking of making a part pre-payment this year. Where do you think interest rates are headed?
- Vaijanath Karve
I have decided to buy an apartment in Greater Noida. But, am unable to decide
whether I should go in for fixed or floating rates? Can I switch between the two after a few years?
- Anurag Varshney
In the current market scenario, is it advisable to opt for a fixed or floating interest rate?
- Prakash Bhogale
I shall answer these queries in three parts.
How a floating rate loan is fixed
A fixed rate loan is really simple.
You take a loan of a particular amount. The company fixes a rate of interest. You pay back the loan over the number of years that you have agreed on when you take the loan.
Since the interest rate remains fixed, your Equated Monthly Installment (the amount you pay back each month) stays the same.
No surprises. No changes.
A floating rate loan is also referred to as adjustable, variable or flexible interest rate loan. In such a loan, the interest rate keeps changing. So, the interest rate on your loan will go up or come down depending on how the interest rate in the economy is moving. This, in turn, will impact your EMI.
Here is how it works.
The home finance company will decide upon a base rate -- known as the floating reference rate. This is generally based on their internal base rate (which every finance company has) called the retail prime lending rate. The interest rate on your loan will be benchmarked against this internal base rate.
The HFC decides how often the interest rate on your loan must be changed. It could adjust the interest rate every year, every six months or every quarter. The more frequently a change is made in the interest rate, the closer it is benchmarked to interest rates in the economy.
Assume your HFC 'adjusts' the interest rate once a year at, say, the beginning of the year. Depending on whether or not the base rate has increased or decreased, your EMI -- or the tenure of your loan -- will accordingly rise or fall the next year.
In India, most HFCs do not have a transparent method of fixing their floating rates. As you can see from above, the rates are linked to specific internal rates of the HFC which are totally within their control.
The good news is that they have at least shifted to a true fixed rate. They have dropped a clause in their agreements that allowed them to change even these fixed rates on certain grounds.
Whether to go in for a fixed rate or a floating rate is a matter of personal choice for the consumer.
If you believe that interest rates are slated to drop in the future, then you can opt for a flexible rate loan. That way, you benefit when the rates fall.
Or, you could even take the fixed option for a few years and the flexible option later.
But, if you opt for a flexible loan, you must also have an appetite for risk and be able to take it in your stride when rates rise.
Let's say you opt for a variable interest rate loan. If interest rates rise, you have two options. Increase the EMI and keep the tenure of the loan constant. Or, keep the EMI constant and increase the tenure of the loan.
Now ask yourself, will the burden of a longer repayment period suit your financial planning?
Or, will you be able to manage a higher EMI should interest rates rise?
If you have the appetite for risk and are financially comfortable with a higher monthly payment or a longer tenure, go for a flexible rate loan.
Where interest rates are headed
Interest rates are widely expected to go up in the future. Keeping this in mind, it is recommended that customers go in for a fixed rate for the time being.
But, do note that the fixed rate option is about 1% to 1.25% more expensive that a comparable variable rate option.
What most consumers do not realise is that this is not a one-time choice but a continuous one that they need to keep making over the tenure of the loan. In fact, I would go so far as to say that the decision should be reviewed every six months at least.
This flexibility will come at a cost. When you switch from a fixed to a flexible option, or vice versa, you will be charged a conversion fee. Also find out how often you are permitted to switch.
You must keep tab of the interest rates in the economy and what is being charged to you to see if you need to switch your rate or lender at any point of time.
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