I keep getting queries from individuals asking me whether they should opt for a fixed rate or a flexible rate for their home loan.
There are two ways of answering this query. One is the long and complicated reply giving all details. The other is the short and sweet response.
I shall give both, but let me start with the long and complicated explanation.
Fixed rate loans
Firstly, it is important to understand what is meant by a fixed rate loan and a floating rate loan.
As the name implies, a fixed rate loan should typically mean the interest rate will remain fixed during the entire tenure of the loan.
So, if you take a fixed rate loan for 15 years at 9% per annum, this will stay put through your 15 year loan period irrespective of whether interest rates rise or fall.
However, in the Indian context, this is not always the case. Loans in which the interest rates are re-fixed at an interval of a few years are also called fixed rate loans. This interval period could be every two years, or three years, or five years, depending on the home loan company or bank.
Fixed rate loan
In this article, when I talk of a fixed rate loan, I will be referring to a true fixed rate loan which remains fixed for the entire tenure of the loan.
Semi-fixed rate loan
In a loan option, where the rate is re-fixed every 'x' number of years, I will refer to it as a semi-fixed rate loan.
Even in the above loans, the banks have clauses in the home loan agreement that allow them to amend their rate of interest on some very vaguely worded eventualities which are to be decided at the bank's discretion.
Signing a fixed rate agreement (or semi-fixed rate agreement) with such a clause makes no sense whatsoever (as the interest rate can be changed at the whim and fancy of the lender).
If your chosen lender insists on retaining such a clause in a fixed rate (or semi-fixed rate) loan agreement, you should switch to a floating rate loan.
Floating rate loans
On the other hand, as far as a floating rate loan is concerned, the manner of its determination is very non-transparent.
The bank will declare a benchmark rate. This home loan rate will be typically charged at a discount (lesser than the benchmark rate) or, in the case of some banks, at a premium (higher than the benchmark rate).
An example will make this clear.
Let's say Bank A is offering you a floating rate loan at 9%.
It will state that its benchmark rate is say, the Mortgage Retail Lending Rate (or some such name that each bank or home loan players gives). This loan at 9% will be calculated at, say, a 1% discount to its MRLR.
Currently, the MRLR is 10%, so your loan will be 9%.
Now let's say that this MRLR changes to 11%. The effective rate of your loan becomes 10% (11% - 1%). That is fine, in principle.
The problem normally occurs when interest rates fall and the bank may choose not to drop the MRLR. Why should they? Except as acting as a benchmark for home loan borrowers, nothing else is dependent on this rate.
It may still pass on the benefit of a lower rate to new consumers. So a new customer may get a higher discount of 2%.
Let's say the MRLR is 10% and, though interest rates have fallen, the bank does not lower it. So, while your rate stays at 9% (MRLR of 10% - 1% discount), a new borrower will get 8% (MRLR of 10% - 2% discount).
Thus, having a transparently determined floating rate is most important.
Some banks like Kotak Bank and UTI Bank link their home loan rates to their fixed deposit rates. This is quite transparent since the bank is likely to keep the fixed deposit rates in line with the current market rate.
Other banks like ING Vysya Bank link the floating rate to the MIBOR, which is a market-determined transparent rate. MIBOR is the Mumbai Inter Bank Offer Rate; this rate is charged by banks when lending to each other for very short-term purposes.
Even in such cases, read your documents carefully to ensure the mechanism for determining interest rates is clearly mentioned in the agreement.
Keep reviewing your decision
The other important thing is for the consumer to realise this is never a one-time decision. Determining what type of interest rate to opt for is an ongoing decision which should be reviewed every six months and modified, if so warranted.
This means that if you opted for a fixed rate loan at the inception of the loan, it does not mean you cannot switch to a floating rate loan in the future and vice versa as well. Of course, the decision to switch should take into account the cost of doing so. You will also need to take into account the interest rate benefits of switching.
Let's take a 10-year home loan. Typically, the cost of fixed rate loans is about 1.25% more expensive than the cost a floating rate loan and about 0.75% more than a semi-fixed rate (assuming the rate is fixed every three to five years).
So if a 20-year floating rate loan is around 9%, a semi-fixed rate loan (where the rate is fixed every three years) will be around 9.75% and a fixed rate loan will not be less than 10.25%.
It makes sense to pay the premium of a fixed rate when you expect the rate to rise sharply in the future even beyond the premium amount.
Thus, the fixed rate loan in the above example will make sense only if the consumer expects the floating rate to climb above 10.25%. As long as the floating rate remains below 10.25%, the consumer will be paying a premium for the safety of a fixed rate of interest.
Whilst it is very difficult to predict the movement of interest rates, often the premium for fixed rate loans is a little too high.
What must one do?
This brings me to my 'easy-to-understand' recommendation. This is what I would do if I was taking a 20-year home loan today.
I would opt for a transparent floating rate loan (linked to the bank's fixed deposit rate or MIBOR).
Alternatively, if I did not mind some amount of risk, I would opt for a transparent semi-fixed rate loan that gets evaluated every three years.
For somebody who is completely risk averse and does not mind the cost of paying a high premium, I will recommend a true fixed rate loan. This option, however, is only for the risk averse. As I have said earlier, it does not make any sense whatsoever to sign a fixed rate (or a semi fixed-rate) loan where the bank retains the right to change the rate at its discretion.
Harsh Vardhan Roongta is the co-founder and director of Apnaloan.com, an online neutral marketplace for home loans and personal loans. A chartered accountant by profession, he has over 21 years of experience in financial services, consultancy and personal finance matters. He is also the author of The Complete Home Loan Guide.
