Home in on the right rate option

In home loans, the nagging question remains: should the borrower choose fixed rates of interest or opt for floating rates?

The decision to choose between a floating rate and fixed rate home loan has always been an important one for borrowers. This topic has been discussed widely and if you do a Google search, you will get some inputs on this. Having said that, it needs a proper perspective. First, let’s get the basics clear.

Floating rate means that the interest rate you are paying now is a function of the rate environment today. Subsequently, as interest rates in the economy move up or down, the rate you pay will move up or down accordingly.

Hence the name ‘floating’ i.e. it floats with some reference benchmark. A fixed rate home loan is a tricky term. While from the name it seems that the interest rate is fixed, there may be a clause in fine print that the loan provider may raise the rate at some point, triggered by some development.

This may be referred to as the so-called fixed or floating-fixed rate home loan, where the interest rate is not as fluctuating as floating, but may fluctuate under certain conditions. Then there is the fixed rate loan, which may be referred to as proper fixed or fixed-fixed rate loan, provided you go through the document or consult a legal professional.

From the loan provider’s point of view, who would be a bank or an NBFC, they would be more comfortable in offering a lower rate of interest in a floating rate loan, than fixed, because when interest rates move up, which will happen because the economy goes through cycles, they can increase your rate.

In a fixed rate loan, in particular a fixed-fixed rate loan, the provider is stuck with the contracted rate of interest. Hence, in a fixed rate loan, from their own margin perspective, they would rather fix the rate on the higher side.

Borrower’s perspective

Now the big question is, from your (i.e. borrower’s) perspective, which one should you choose? If your loan is for a short tenure, say five years, floating rate is preferable as you are availing of a lower rate to start with.

Bear in mind, interest rates may move up. Even then, since the tenure is not too long, and given that economic cycles take time to play out, it is expected that for a better part of your loan tenure, you would be paying a rate lower than the fixed one. Currently, banks are offering floating rate loans only and not showcasing fixed rate EMIs as the differential is significant.

That is, fixed rate loans are at a much higher rate than floating rate loans and it does not make sense to offer it to customers. NBFCs on the other hand, are offering both, fixed and floating. This helps you evaluate where you would break even if interest rates were to move up.

The flip side is, if the fixed-rate loan is so-called-fixed and not real fixed, you may be under the impression that you are buying peace of mind, by assuming EMIs would not move up, But you never know.

Now, if your loan is for a long tenure and you start with floating rate, the interest rate cycle may reverse and you may end up paying as much as for a fixed rate loan. If that happens, you may shift to a fixed rate loan so that you know for certain what you will end up paying. Although, there would be charges/fees applicable for the switch. But if the loan amount is not too small, it is worth it. Nowadays, information is easy to access online; when the rate cycle reverses after, say, a year or two, you can track fixed rates across providers and optimise by shifting.

Current situation

A change in rules for floating rate loans were made about a year ago. The RBI circular of September 2019 stated that all new floating rate loans offered by banks from October 2019 onwards should be marked to an external benchmark.

A pet peeve of banking loan customers, and rightfully so, used to be that banks are quick to raise loan rates when interest rates move up, but slow to reduce when rates ease. The options for a bank in using external benchmarks are the RBI repo rate or the 3-month/6-month treasury bill yield. It was also stated that the interest rate under external benchmark shall be reset at least once in three months. An external benchmark is one the fixing of which is not decided or influenced by the bank.

For example, repo rate i.e. the rate at which RBI lends to banks for one day, is decided by the RBI, hence external. With external benchmarking, transmission of rates will be faster on both sides i.e. up and down.

The spread maintained by banks is currently on the higher side; with the repo rate at 4% and the lowest rate being at 6.75% and most of the rates being upwards of 7%. The RBI circular stated that while banks are free to decide the spread over the external benchmark, ‘credit risk premium may undergo change only when borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract.’ Banks are protecting their margin. If interest rates were to move up in future, at the same spread, the rate would be that much higher.

Interest rate cycles will move over a long tenure, and nobody can time them.

Rather, when rates actually move, you can compare the options between fixed and floating, subject to charges. As of now, a floating option is better as the rates are lower with one bank offering 6.75%. You are starting off with an advantage of a low rate and you are aware it may move up, instead of being under the illusion of a so-called fixed rate loan.

(The writer is a corporate trainer in debt markets and an author)

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