Whether to choose a fixed rate loan, which is easy to budget and has an element of certainty with it or to choose a floating rate of interest that provides the benefits of decreased interest rate, is a classic dilemma that has puzzled Loan seekers for ages. Here we take a look at the benefits and drawbacks of both the fixed and floating rate loans.
When availing a loan, 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 remains fixed throughout the loan period. But these kinds of interest rates are comparatively bit higher when compared to floating interest rate and only a few lenders offer this option.
Fixed interest rate loans allow the repayment in fixed equal monthly installments over the entire period of the loan. The interest rate in such a case is fixed and doesn’t change with market fluctuations. During the early part of loan tenure the majority of monthly payments are used to service the interest and principal is served in the later parts of loan tenure.
The benefit of such loans is that because the interest rate is fixed, even if the market pressures push the interest rates to high levels, the borrower pays a fixed Equated Monthly Installment (EMI). A fixed rate loan is excellent for those who are good at budgeting and want a fixed monthly repayment schedule, which is easy to budget and doesn't fluctuate. Thus fixed rate loan brings a sense of certainty and security.
The major drawback with fixed rate is that it is usually 1 - 2% more than the floating rate loan. Secondly, if for any reason the interest rate decreases, the fixed rate loan doesn't get the benefit of reduced rates and the borrower has to repay the same amount every time. Another area of concern is whether the fixed rate loan is 'truly fixed' or fixed for just few years. This has to be ascertained while taking the loan. A ‘fixed’ loan, which can be changed every few years, will definitely wipe out the very spirit of such a loan. Experts agree on the fact the fixed rate are a better option if the economic scenario promises a rise in interest rates in near future.
Floating interest rates are also known as adjustable, flexible or variable rate of interest. In this case effective rate is linked to the Bank’s Base rate. The advantage for customer in this case is that when market rate softens banks are forced to reduce their base rate and customer end up paying lower interest. Similarly 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.
Floating interest rate loans are tied up to a base rate plus a floating element thereof. So, if the base rate varies the floating interest rate also varies.
The biggest benefit with floating rate loans is that they are at least 1%-2% cheaper than fixed interest rates. So, if you are getting a floating interest rate of 11.5% while, the fixed loan is being offered at 14%, you still save money if the floating interest rate rises by up to 2.5%. Even if the floating rate goes over the fixed rate, it will be for some period of the loan not for the entire tenure. The interest rates will surely fall over a long period and thus floating interest rate brings a lot of savings.Disadvantages of floating interest rate loan
The drawback with floating interest rate is the uneven nature of monthly installments. This makes it difficult to budget with floating interest rate loans. As seen in recent times due to the hike in floating loan interest rates, the borrowers had to shell out thousands per month extra as their EMI's, throwing their entire budget out of order.
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.
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%.
When it comes choosing the interest rate regime, majority of loan borrowers, in fact over 90% of them go for a floating interest rate loan. Finally, it is up to the borrower to decide on what suits him the best. Ideally the borrower should compare loans for various parameters and understand every single detail about it. If certainty and security are prime considerations, a fixed rate loan will be the best; however it won't come without the premium on interest rates.