Choosing Home Loans: Fixed vs Floating Interest Rates

Taking out a home loan is often the largest financial commitment someone makes in their lifetime. Choosing the best interest rate is a crucial part of the decision-making process when shopping for a home loan. Floating or Fixed interest rates?

What’s better for me? It is an important decision while choosing a loan plan. But different people have differing personal opinions about which one is better. We have complied the comprehensive guide for everything about fixed and floating rates. It is time to stop looking everywhere and getting confused.

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Differences at a Glance

Aspect	Fixed IR	Floating IR
Definition	The interest rate remains constant	The interest rate can change periodically
Stability	Stable, providing predictability	Can fluctuate, leading to uncertainty
Risk	Lower risk of interest rate changes	Higher risk of interest rate changes
Duration	Typically for a fixed period (e.g., 5, 10 years)	Can change at specified intervals (e.g., annually)
Market Influence	Not affected by market interest rate changes	Directly influenced by market interest rate changes
Borrower Preference	Suitable for those seeking long-term stability	Suitable for those comfortable with market fluctuations
Payment Consistency	Monthly payments remain constant	Monthly payments may vary based on market rates
Refinancing Impact	May not benefit from falling interest rates	Can benefit from falling interest rates by adjusting down
Predictability	Offers predictable monthly payments	Monthly payments may vary, making budgeting more challenging
Initial Rate	May start higher than initial floating rates	May start lower than initial fixed rates
Flexibility	Less flexible if interest rates decrease	More flexible if interest rates decrease
Example Loan Types	Fixed-rate mortgage, fixed-rate personal loans	Adjustable-rate mortgage, variable-rate loans

Fixed Interest Rates

A fixed interest rate is a rate that stays the same over the full term of a loan or savings account. This means your interest payments or earnings don’t change over time.

Here’s an easy example:

Say you take out a ?7,00,000 loan with a 5% fixed interest rate and a 5 year repayment term. This means that over the 5 years you’re paying back that loan, the annual rate will stay fixed at 5%.

The annual interest payment will be ?35,000 in the first year (5% of ?7,00,000), and it will stay at ?35,000 in the second year, third year, and so on until you fully repay the loan.

Even if market interest rates rise to say 8% over those 5 years, your annual interest payment will remain unchanged at ?35,000 because you locked in the 5% fixed rate from the start.

The main benefit of a fixed rate is having predictability – you know exactly what your interest costs or earnings will be each year. The main risk is if market rates go up or down substantially, your rate stays locked in place. So if rates in general rise to 7%, you’d still have your 5% fixed rate from when you originally took out the loan or opened the savings account.

Fixed interest rate is often the preferred choice for consumers when the financial markets are weak. By fixing their rate based on their economic outlook and risk tolerance, borrowers can take advantage of the opportunity to secure a low, stable rate before an expected rise. Rather than face potential increases in variable rates in the future, consumers who foresee interest rates holding steady or rising can benefit from the certainty of an unchanging fixed rate. In uncertain times, choosing a fixed rate mortgage or loan shields borrowers from market volatility.

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Floating Interest Rates

A floating interest rate is a rate that changes or ‘floats’ based on the market conditions and benchmark rates. Here is an easy explanation with an example in Indian Rupees:

Suppose you take a home loan of ?50 lakhs from a bank at a floating interest rate that is tied to the RBI’s repo rate. This means your interest rate will go up and down based on changes in the repo rate decided by RBI.

For example, if the repo rate set by RBI is 5% when you take the loan, your annual interest on the ?50 lakhs loan will be calculated as:

5% of 50 lakhs = 2.5 lakhs

So your annual interest is 2.5 lakhs initially.

Now if RBI increases the repo rate from 5% to 5.5%, your rate will also rise along with it. Your new annual interest at 5.5% on the ?50 lakh loan will be:

5.5% of 50 lakhs = 2.75 lakhs

So you now pay 25,000 more in annual interest.

The key thing is your rate and interest payments keep changing based on the external benchmark rate set by RBI. This floating rate gives you lower initial interest, but the risk is that the rate can go up substantially over the loan term if repo rates rise.

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Nowadays, floating interest rate is becoming more popular and is considered as the first choice of home buyers. Even banks and NBFCs are offering home loan interest (floating) at a low and attractive rate.

Can I Switch Between Fixed and Floating Interest Loans?

Yes, it is often possible to switch between fixed and floating interest rate loans. Here is a simple explanation:

When you first take out a loan, you usually can choose a fixed or floating interest rate. If you choose a fixed rate loan, the rate will stay the same for the full loan term. If you select a floating rate loan, the interest rate changes based on market conditions.

Most banks and lenders provide the option to switch your loan from fixed to floating or vice versa after a specified period of time, usually a few years. There is typically a nominal switching fee involved.

For example, if you have a 20 year home loan at a fixed rate of 8.5%, after 5 years you may have the option to switch to a floating rate that is currently lower, say 7.5%. Doing so would lower your immediate interest payment amount. However, the risk is that the floating rate could later go higher than your original fixed rate.

If you have a floating rate loan and projections show that rates will rise substantially in the near future, you can usually pay the switching fee and convert your loan to a new fixed rate loan to lock in a low fixed rate before the rises happen.

So in summary – you usually don’t have to stick to the initial choice of a fixed or floating loan. Paying a small admin/switch fee gives you the flexibility to change options later as needed to meet your budget or expectations.

Conclusions

It’s important to note that the choice between fixed and floating rates depends on individual preferences, risk tolerance, and market conditions while choosing your home loan interest rate. 

Customers in their late 40s often prefer fixed rates, as they typically have 15-20 years left until retirement. With a fixed rate, their interest costs and EMIs stay predictable and stable even if market rates rise over time. This helps ensure loan repayment by retirement. Additionally, people in their 40s are less likely to take on major new debt compared to earlier in life.

In contrast, customers in their late 20s may benefit more from floating interest rate loans. They have several decades left in their careers, so there is substantial time to repay loans even if rates rise a bit at times. More importantly, their longer time horizon means they have higher chances to take advantage of decreasing rate environments and substantial interest savings over 30 year loans. Even if rates increase moderately, the longer tenure allows easing the burden by extending the repayment period slightly.

In summary, fixed rates provide stability and predictability mostly beneficial later in life, while floating rates provide flexibility and potential interest savings that fit better with long-term loans earlier in one’s career.

Each type of interest rate has its advantages and disadvantages, and borrowers should carefully consider their financial situation and goals when deciding between them.

To calculate EMI, various factors including the principal amount, interest rate, and loan duration are considered. The EMI is derived using a specific mathematical formula that takes all these elements into account. You can try Credit Dharma’s EMI calculator to check it for yourself.

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