A Comparison Of Fixed And Floating Interest Rates

While scouting for home loan, choosing interest rate is perhaps a biggest dilemma confounding borrowers.  Whether you should opt for fixed rates, which are easy to handle with minimum of fuss or go for floating rates, which are generally cheaper and has better room for negotiation has always remain a million dollar question. The decision is crucial as it impacts your finances for, at least, 10-20 years.

Let’s analyze the impact of fixed and floating rates on your future cash flows with an example. Aryan is in hunt of a home loan of Rs 10,00,000 and approaches Allahabad Bank, which is offering the requisite loan at a fixed and floating rate of 12.25 per cent & 11.25 per cent respectively. On the face of it, floating rate of interest looks attractive, but is apprehensive about future rise in interest rates. So, how should he go and what should he choose?

At the very outset, flat rates are more expensive than reducing balance rates. This is because under fixed rate scenario, the total interest paid per year remains constant throughout the loan tenure; whereas under reducing balance, interest payout diminishes in subsequent years/ months on account of lower outstanding, as reduced by your yearly/ monthly payout.

The table below shows the net savings the Aryan could make by choosing floating rate of interest. Under the fixed rate option over the 20 year duration, Aryan would have paid an interest of Rs 24,50,000, as compared to Rs 15,18,320 under floating rate option.

Fixed Rate Vs Floating Rate of interest

In reducing balance option, choosing a right rest is important. A ‘rest’ is defined as the time period or interval at which the reducing (outstanding) balance is recalculated. It could be monthly, daily, quarterly, half yearly and yearly. In case your EMI and rests period differs, e.g. you pay installments on monthly basis, but reducing (outstanding) balance is recalculated only yearly, you are paying interest on the same outstanding principal (for 11 months) when you have reduced your balance every month. The case is highlighted above when Aryan is paying an extra interest of Rs 34,320 over 20 year period. So, it’s imperative for you to ensure the periodicity of repayment that closely matches the frequency of your rest period to make the most of your reducing balance option.

However, choice of floating rate of interest is not that easy. The question depends on a host of factors. First and foremost, the prevailing interest rate regime. A floating-rate option is a wise in a falling-interest rate scenario; however, it becomes costly when interest rates start rising. Of late, this has been the trend as RBI has hiked key policy rates ninth times since March, 2010. Only recently in its annual policy review on May 3, 2011, RBI has hiked the repo rate by 50 basis points. This means, anyone who has taken a home loan after March, 2010 on a floating rate, ends up paying more.

However, currently interest rates are close to its peak and it is widely expected that from second half of the year, interest rates are headed southwards. So it might just be a right time to opt for floating rates, if going for fresh housing loan. Switching from fixed rate to floating rate is another option, but it comes at a cost. Usually, bank charges up to 2 per cent of the outstanding loan amount for converting it from fixed to floating and vice-versa.

Another reason that may impact your choice of interest rate is your age. If Aryan is amongst the younger loan borrower, it makes more sense to opt for floating-rate scheme, given his robust earning potential and the time available for him to pay off debts. However, older people might not have that advantage and could prefer fixed interest rates. It could also depend upon your risk appetite. If you are a risk-taker, you might opt for a floating-rate scheme. On the other hand, if the prospect of higher interest rates gives you sleepless nights, it is better to opt for fixed-rate scheme.

Finally, it is up to the borrower to decide on what suits him best. Ideally, the borrower should compare home loans for various parameters and understand every single detail about it. If certainty and security are prime considerations, a fixed rate home loan will be the best.