Buying a property is one of the biggest investment that most of us make in our lives. With the investment requiring significant capital, many of us have to rely on financing institutions to make the scale of investment more manageable for us. Financial institutions offer different financing options that can cover majority of the property cost, which can be repaid in installments or EMIs spread over 10-30 years. Property loans are offered under two main financing options – fixed rate and floating rate. It is important to understand the difference between the two options, as each can have an impact on your overall financing cost, and impact your return on investment.
The Difference between Fixed and Floating Rate
A fixed rate loan is a loan wherein the monthly repayment installments are equal for the duration of the loan period that you have agreed with the bank. This means that a borrower pays the same amount monthly for the agreed time to the lender. The fixed rate is mostly determined by the amount being borrowed, the period of borrowing, and overall market situation.
A floating rate loan is a loan wherein the rate of interest changes periodically, based on a combination of factors such as the inflation rate, overall economic conditions, liquidity and the Reserve Bank of India (RBI) measures. Banks use the benchmark Prime Lending Rate (PLR) to set the lending rates. As it fluctuates, the floating rates also change accordingly, causing proportionate change in your monthly installments or EMI 폰테크.
Benefits and Drawbacks of Fixed and Floating Rate Loans
Benefits of Fixed Rate Loans:
Fixed rate loans being “fixed” offer a sense of comfort and certainty related to installments to borrowers. The option shields borrowers from changing market conditions and interest rates, and allows them to pay as per the amount agreed with the bank. This option is ideal for individuals, who are risk averse and do not wish to have any changes to their financial plans.
Drawbacks of Fixed Rate Loans:
Fixed rates loans tend to be more expensive compared to floating rates, as in case of these loans the lender has to assume the risk of any interest rate fluctuations. The higher interest rate charged by the financial institution, is mainly to guard against increase in interest rates by RBI, which will not affect fixed rate loans.
The benefit of acting as a shield to market conditions, starts acting as a drawback for fixed rate loans in a declining interest rate market. Such situations force a fixed rate loan borrower to pay higher interest rates even if interest rates in the broader market are much lower. Given that fixed rate loans are already configured to be higher than floating rate, a declining interest rate market can make such loans extremely expensive, driving up the cost of property purchase and reducing overall return on investment for the borrower. Also, as economies mature, the demand for credit tends to show a decline, which pushes down interest rate. If home loans are taken for a period of 20-30 years, it is likely that interest rate in India will show a decline over longer duration, and thus relying on fixed rate over a longer time frame can be risky.
Benefits of Floating rate:
The reason most home buyers prefer floating rate loans is that these loans are 1-2.5% cheaper than fixed rate loans. Thus, in a scenario when interest rates increase by 2%, a floating rate loan taken at 11% can still be cheaper than a fixed rate loan taken at 13.5%. Also, when interest rates fall, borrowers can gain significantly by choosing to lower installments, or by reducing the loan tenure by continuing to pay the same installment or EMI.
Drawbacks of floating rate:
A floating rate is not predictable, and is completely governed by market forces. When the interest rates shoot up, borrowers are asked by banks to pay higher EMIs. A floating rate allows a borrowers to enjoy low interest rates; however, it does not shield them from unexpected interest rate increases. These loans can prove particularly challenging for households that have taken loan up to the maximum permissible limit in a market that is experiencing increase in interest rates. For example, an installment for an INR 2.5 million loan for a period of 20 years at 10% per annum results in a monthly installment or EMI of INR 24,126. The same installment goes up to INR 29,289 if interest rates increase to 13%. As the example indicates, borrowers are often pushed into absorbing higher EMIs when rates increase, and when their income does not allow them to pay higher EMIs, they either default on the loan or are pushed to increase the term of their loan to keep it sustainable.