Terming a decision between floating or fixed interest rates a “dilemma” might not be an understatement. Whether you are looking to fund your education, business or a new home, the choice is an essential step in the process of financing your needs. There are essentially two types of interest rates – Fixed and Floating .
A fixed interest rate allows you to repay your loan amount with a fixed percentage of interest and in Equated Monthly Instalments (EMIs) for the entire tenure. The methodology is considered safer due to its protection against fluctuations. On the other hand, a floating interest rate loan leads to a variable interest rate depending on economic scenarios. The rate is linked to the marginal cost of funds-based lending rate (MCLR).
As per this logic, if the interest rate cycle is expected to rise, it is prudent to opt for a fixed interest rate on your borrowing. It is essential to read the terms and conditions attached to your loan as certain banks can reset the interest rate or link to a floating rate after a fixed period of time.
The advantages of a fixed interest rate include stability on the rate throughout the tenure (with exceptions) to calculate the budget required for repayment easily. However, if the interest rate cycle goes down, you cannot access the benefits related to the lower rate of interest. You could opt for a fixed rate if you prefer to work with a fixed repayment schedule and your proposed EMI is less than 30 percent of your monthly salary. It’s a safer option tis way. While this is a gamble, let us discuss the benefits of a floating rate.
The floating rate loan is approximately 1 to 2.5 percent cheaper than the fixed rate loan. Opting for a floating rate can lead to savings over the tenure of the loan due to its dependence on interest rate cycle fluctuations. A disadvantage of this option is that planning your finances for the tenure of the loan can be considerably difficult. It could be a challenge to obtain an accurate prediction of your monthly payables. You should opt for a floating interest rate if you foresee a decrease in interest rates in the future or want to depend on market rates due to a lack of expertise on interest rate cycle fluctuations.
In future, the interest rates on home loans and other retail loans are expected to be linked to external benchmarks as opposed to MCLR. Banks will be required to select a uniform external benchmark for a loan category. This move might create transparency and standardization and enable customers to make better buying decisions.
The decision to select a floating or fixed rate loan is a personal one and depends on your ability to take the risk. While both types of interest rates come with their own set of advantages and disadvantages, you should select the one that complements your needs the best. The fixed interest rate can ensure security and certainty to ease your mind, while its counterpart could help you access unexpected financial gains.
You should consider the different plans available with financial institutions before making the final call. If you are still unsure about the suitable type of interest rate, you have the option to take on a loan and switch between the fixed and the floating rate at any point in time. Ideally, the lender will levy a nominal fee to provide this facility. Therefore, even though your choice of interest rate will impact the cost of acquiring an asset, you have flexibility in selecting the right one through the tenure depending on your needs.
(By Rishi Anand, Chief Business Officer – Aadhar Housing Finance)