Should You Opt For A Fixed Interest Rate Or Floating Interest Rate Home Loan

Has Sunita taken the right decision?

Sunita, a 35-year-old widow, is surviving on a steady monthly income of Rs 30,000. She had taken a loan of Rs 15 lakh in 2004 on floating rate for 7 years. She could also have opted for a fixed rate which was being offered at 8 per cent p.a. at that time. But since the floating rate was lower than the fixed rate and she had no other means to support her family, she tried to be frugal with her finances and chose floating rate. Has it turned out to be a correct decision for her? Let us analyse the entire situation in four steps given below.

Floating Rate EMI for Sunita

Let us first consider the interest rates that would have been applicable to Sunita each year based on the floating rates -

Assuming that the tenure of the loan remains the same, i.e. 7 years, for the floating rate and all adjustments are made only w.r.t. EMI of the loan, the amount paid per year by Sunita for the floating rate loan would be -

Fixed Rate EMI for Sunita

There was a second option present for Sunita in the form of fixed interest rate. She could have availed the loan at the prevailing fixed rate of 8 per cent p.a. In this case, the EMI for her Rs 15 lakh loan would have been Rs 23,379.

EMI – Fixed (8 per cent) vs Floating

Let us, therefore, compare both floating and fixed rates over the tenure of the loan. Here, the fixed rate is 8 per cent as offered in 2004.

The graph suggests a rise in the floating rate EMI in comparison to the fixed rate EMI after the second year. So we see that post 2005, Sunita has actually paid much more under floating rate than the amount she would have paid had she taken the loan on a fixed rate basis in 2004. Therefore, given the rates, opting for a fixed rate loan would have been a better decision for Sunita.

EMI – Fixed (10 per cent) vs Floating

However, let us see what would have happened had the fixed rate of interest been around 10 per cent at that time. In this case, the EMI for Sunita would have turned out to be Rs 24,902. (Calculate the EMI here) Now let us compare all these options.

Here, we see that for the first three years of the loan there is a wide gap between the fixed rate (10 per cent) EMI and the floating rate EMI – latter being the lower. In this case, therefore, opting for a fixed rate loan wouldn't have yielded much benefit to Sunita, given her 7-year horizon.

Floating Rate vs Floating Rate

Another issue that we would like to highlight here is that the comparison is not always between just the fixed and floating rate loans, but the rates across years for floating rate loans also vary widely. This is because banks generally fixed the discount per cent over PLR for each customer when he/she takes the loan. However, this discount per cent is different over different years and favours new customers in most cases. To understand it better let us look at the discount rates offered to new customers in the recent years.

Thus we see that for someone who had taken a loan in 2004, it might not be very beneficial to prepay and take a new floating rate loan in 2005 or 2006. But it definitely makes sense to do that 2007 onwards as the benefits on discount rate would more than compensate for the cost of prepayment of loan.

Summing It Up

• Floating rates can vary in a band of 7-15 per cent, especially between 8 per cent and 13 per cent.
• Impact of floating rates on loans with tenures of 15-20 years is very high. It can lead to an increase in the EMI by almost 30-40 per cent, over a few years.
• Floating rates are usually 1-2 per cent less than fixed rates.
• It makes sense for locking in a fixed rate when the rates are low.
• Since banks do not pass on benefit of low rates to existing customers, but to new customers, it makes sense to prepay and go for a new loan.
• However, if fixed rates are too high, and 2 per cent or more above floating rates, then it is advisable to go for floating rates.
• If fixed rates are too high, say above 13 per cent, again it does not make sense to go for fixed rates. One should wait for the rates to fall, and till then remain in floating.
• There may be a fee charged for shifting to a fixed rate loan or to a floating rate loan within the same bank. However, you can also pay a prepayment fee and shift to another bank, changing from fixed to floating.
• Be cautious as fixed rates are not fixed for the entire duration of the loan, but only for 5 years, and can be reset after that. Please check this with your bank.