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Sunil Nayanar |
December 22, 2003
There is one vexing question that all home loan seekers have to address: whether to go in for a floating-rate scheme or take shelter in a fixed-rate scheme.
Given the volatile nature of the home loan market, which is linked to various macro economic developments, most find the floating-rate strategy the better option.
In fact, almost 90 per cent of the existing housing loans in India are said to be disbursed under floating-rate schemes. Not surprising, considering the current soft interest rate regime.
However, the path is strewn with thorns. Any upward movement in interest rates will see an increase in your EMI (equated monthly installment) or your loan tenure, meaning the number of EMIs that one has to pay.
Does that mean that fixed-rate schemes are the better option?
While it spares you the headache of tracking changes in interest rates or worrying about your EMIs as the rates are fixed for the loan tenure, any further lowering of interest rates could make you regret the decision to go for the fixed-rate option.
So how do you find peace of mind? The question depends on a variety of factors, say experts. First and foremost, the prevailing interest rate regime.
You also need to check out the different rates offered for different tenures, and the costs of switching the loans later. The difference between fixed and floating rates also comes into the picture.
For a better understanding let's look at what floating- and fixed-rate schemes actually mean.
Fixed loans (EMI/Rs 1Lakh for 20-year loan)
Tata Home Finance
Floating loans (EMI/Rs 1 Lakh for 20-year tenure)
(The rates for some of the above institutions are official rates mentioned in the brochures or prime lending rates. These are subject to discounts and negotiations.)
A floating rate or variable rate is one where the rate charged by the housing finance company on your loan is liable to change as and when the broad interest rates in the economy change.The interest rate charged on housing loans tends to vary with a benchmark, which is generally the prime lending rate.
The change in interest rate is reflected either in the form of a change in the EMI on the housing loan or a change in the tenure of the loan.
When the interest rate falls, the EMI is also likely to fall or the tenure may be reduced. If the PLR moves up, the interest rate on your loan would move up, raising your EMI.
The catch lies in interest rate movements. You are exposed to interest rate risk in the case of a floating-rate loan scheme.
If the interest rates move upwards, you could be faced with a large, unplanned increase in outgoings in the form of soaring EMIs.
According to loan experts, a floating-rate scheme is best suited in a falling-rate scenario. But it becomes costly as and when the rates move up.
Most banks offer floating-rate loans at an interest rate that is slightly lower than that of fixed-rate loans.
Keeping in mind the fact that loans are reviewed on a three-month or six-month basis, a change in the floating rate on a loan would depend on the level at which the customer had applied for the loan.
The loan could be below the PLR, above it or at par.
If a loan is sanctioned at, say, 3 per cent below PLR, and the present PLR is around 10.5 per cent, the borrower would pay 7.5 per cent interest.
If PLR becomes 10 per cent, the rate would be 7 per cent. But on the other hand, if the PLR rises to 11 per cent, the borrower would have to pay 8 per cent.
The good thing about a fixed-rate scheme is that the interest rate charged by a housing finance company remains fixed throughout the term of the loan.
Which means that the consumer is immune to fluctuations in interest rates. The risk of rising interest rates is borne by the financing company in this case - a rise in interest rates will not affect your cash flows.
It also offers the advantage of knowing your liability per month (EMI) in advance, which remains fixed throughout the term of the loan, enabling better financial planning.
On the flip side, you do not benefit from a fall in interest rates. So, even if you earn less on your bank deposits in case rates fall, you will be forced to pay a higher interest rate on your loan.
It is advisable to go in for a fixed-rate scheme if one feels that the rate of interest in the market has touched rock-bottom and hence they may have nowhere to go but up.
The pros and cons
As said earlier, a vast majority of Indian housing loan consumers have opted for floating rates primarily because soft interest rates have been prevailing in the last three years.
However, experts point out that we have only seen one side of the curve, and are largely unaware of the pitfalls if interest rates start going the other way.
But with most home loan companies offering the option to switch from floating to fixed rates and vice versa, you may think there is no need to worry. Wrong.
Switching loans is fraught with its own perils. One can shift a fixed-rate loan to a floating-rate one only by paying a penalty.
A shift from floating to fixed is not allowed by many companies, since they are fully aware of the chances of interest rates going up after touching historic lows. And even if you manage to get your loan shifted to fixed, you may have to pay a heavy premium for the pleasure.
For example, banks like SBI and ICICI Bank give their existing customers the option of shifting from floating rates to fixed for a fee of 2 per cent and 1.75 per cent respectively of their outstanding principal.
Customers also have the option of shifting to new floating-rate schemes, which are introduced at frequent intervals by housing companies to lure new customers.
But you are charged a fee for the service, which currently varies from 0.5 per cent to 1 per cent of the outstanding principal amount, depending on the loan provider.
While moving your loan from fixed to floating rates within the same company involves only a switching cost, shifting your loan to another company is a more expensive option.
If you are moving from the fixed-rate loan of one company to a floating-rate loan of another, you have to pay prepayment penalty charges to the former.
The latter may charge you processing fees since it considers your switch as a fresh loan application. (Some banks may, however, waive this if they are desperate to grow their loan books.)
Typically, for fixed-rate loans, most banks charge a higher rate of 0.25-0.50 per cent over floating rates. Even then, most industry analysts prefer a fixed-rate loan rather than a floating-rate one.
And with good reason, too.
According to them, since most housing loans are usually for 15-20 years, any rise in interest rates, even if it happens three-four years down the line, can have a very negative impact on tight financial planning.
When that happens, you are left with not much option but to try to pre-pay the loans as and when you can. Refinancing your loan is one options in that case.
That is, take a fresh loan from another housing finance company to repay the existing loan. But again, you will be charged a refinancing penalty of about 2 per cent of the principal outstanding on your loan.
According to analysts, refinancing makes sense only if you have already pre-paid a substantial proportion of the principal due on the loan.
However, if you have just started on your loan repayment, the burden of refinancing can be quite heavy.
What are experts advising customers to do? Most of them support the fixed-rate option. Since interest rates seem to be at a low currently, most of them believe that it can only move upwards - even if it doesn't happen in the immediate short-term.
They also point out that market rates are better than ever. With a fixed rate of 8 per cent available even for 20-year loans, it makes better sense to get into fixed-rate loans rather than getting locked into a floating-rate loan and risking the consequences of rising interest rates in future.
What do you do?
The answer is not that simple. The decision to choose your loan depends on a lot of factors. Your age, for instance.
If you are a young loan seeker, it makes sense to go for a floating-rate scheme, assuming that your earning potential and the time available make it easy for you to pay off your long-term loan.
While a floating-rate scheme could help you save when interest rates move downwards, you can also cushion the impact of rising interest rates because of the options available to prepay through refinancing or switching your loans.
However, for older people it makes more sense to take advantage of the current low rates, which lessen their monthly EMIs.
You need to have a better understanding of the interest-rate scenario and the frequency of changes made by your loan institution in terms of rates.
You also need to take into account the different rates offered for different tenures and the cost of switching loans. There are some thumb rules even for a baffling market like housing loans, say experts.
Keep in mind the fact that fixed rates are better suited for long-term loans with an average life of 10-20 years while floating rates can be considered for short-term borrowing. It also depends on your risk appetite.
If you are one of those who like to take risks, then go for a floating-rate scheme with the hope that interest rates stay low for many more years.
But if the thought of higher interest rates gives you palpitations and stress, it is better to opt for a fixed-rate scheme.
But above all before you sign the loan agreement with any housing finance company, make sure to go through the fine print carefully. For therein lies the real tale.