Floating vs fixed interest rates How loans work

Published: 01st March 2010
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There are two interest payment options you can choose from when applying for a home loan -fixed rate and floating rate.
A fixed rate is where the rate of interest is fixed throughout the tenure of the loan. Generally, most banks keep the rates fixed for a maximum of 5 years.
A floating rate is where the rate of interest is benchmarked against a specific interest rate (usually the bank's internal rate), and fluctuates according to the benchmark.
Usually, you can strike a floating rate loan at a lower rate than a fixed rate loan, the difference being around 1 to 2 per cent.
If the interest rate of a floating rate loan rises, banks first increase loan term or the duration of the loan.
Otherwise, they can even increase the amount of your EMI.
Which rate to choose?
Keep the following factors in mind while deciding whether to opt for a fixed rate or floating rate: Outlook: When interest rates are high, it makes sense to go in for a floating rate loan, as a fall in rates will benefit you. And if interest rates are low, it is advisable to lock in a lower fixed rate for at least 3-5 years.
Stage of life: If you are a senior citizen, or somebody with a fixed source of income, you cannot afford an increase in EMI and should go for a fixed rate loan.
Fixed rate loans are not fixed In the world of finance, nothing is certain, especially where the loan segment is concerned. There is a lot of fine print that has to be read carefully before any decision is made because it can come back to haunt the person at some later stage. Investors as well as borrowers in India have experienced this in the last few years and hence this area needs extra attention.
In common parlance, the term fixed rate loan can be distinguished from the floating rate loan on the basis of the manner in which a borrower will pay interest on the loan. In a floating rate loan, the rate paid is linked to some other rate, usually a benchmark rate, fixed by the lending institution. Changes in an economy have an impact on the benchmark rate and the borrower also experiences a change in the rate that he/she will pay. As opposed to this a fixed rate loan will have a fixed rate of interest to be paid on it.
Many people believe that the rate of interest once fixed remains fixed for the entire duration of the loan. This is what is supposed to happen but some clauses in the loan agreement render this false.
This means that the fixed rate will also change; the only difference will be the frequency at which it will change.
There are two factors that lead to a change as far as the fixed rate is concerned. In many agreements, the rate is fixed for only a specific duration of time. This time period can be of three years or five years and the rate of interest can change after this period is over. After this the lender can once again fix the rate for some additional time duration and this will be done based upon the situation prevailing at that point of time. So, if there has been a rise in the rates due to some reason, the fixed rates will be revised upwards and the individual can get trapped because the higher rates will then be applicable for the next fixed time period.
This can also happen through a clause that says that in case of an emergency situation in the economy or massive disruptions in the debt market, the rate of interest might change. What this situation will be is not clearly defined and is open to interpretation. Due to this reason borrowers will always be on the edge. In the event of such a situation, the loan will no longer have the characteristics that the borrowers believed were present initially.
A word of caution All banks lend floating rate loans at a discount to a benchmark rate called `Prime Lending Rate' (PLR). This benchmark rate and the amount of discount are an internal matter for a bank, and this can affect a customer.
Let's look at the movement of PLR and average discount of some private banks: The rates have increased from 8 to 12 per cent in around three years.
While the rates of interest for a new customer have fallen, those for the old customers are still increasing.
Chances are that the discounts can go on increasing, but the PLR will not fall.
So, if you want to avail of better rates, go in for prepayment and take a new loan. It might be worthwhile in spite of the 2 per cent prepayment fee.
Most private banks have increased the interest rates heavily, whereas public banks have been much more moderate.
How good is fixed-cum floating interest rate?
Borrowers always find it difficult to choose between a fixed rate loan and floating rate loan, and in recent years, they have to consider one more option -fixed floating rate loan.
In this loan type, the interest rate is fixed for an initial period, which later gets converted to a floating one.
What should a customer do? Consider the impact beyond year one while taking the loan. If interest rate for a new loan is deliberately kept low to attract customers, any change can lead to a spike in the EMI. This will mean a large discount in the first year on the prevailing interest rate. The rates might not conform to the rising trend of interest rates in the future.

Courtesy: HT Estates 20th Feb 2010
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