Fixed vs. floating interest rate: which one to choose?

Shikha, 40, mother of two, is an IT professional. She has lived with her parents since her husband died five years ago. She thinks the time has come to buy her own house. She has approached lenders for a home loan and must choose between a fixed rate loan and a variable rate loan. Which one should she choose? This choice will affect not only his EMI exit but also his repayment plan.

Shikha should know that it is more difficult to predict future interest rates than it is to decide how many EMI she can comfortably pay. A fixed rate home loan in which the interest rate is prefixed for the term of the loan provides a known cash outflow for a known period. The risk for Shikha is that this may turn out to be a high rate that she locks into for a long time in the future.

In a variable rate home loan, the interest rate changes on a quarterly basis based on market interest rates during the term of the loan. It will be affected by the change in the base interest rate indicated by the bank, which in turn is linked to market interest rates and economic factors. Lenders usually adjust the term of the loan and keep the EMI constant in variable rate loans. Should interest rates fall in the future, Shikha will benefit from a reduction in its repayment term. If the rates increase instead, its repayment term may increase.

In either case, it is on the EMI that Shikha should focus on first, and making sure that she is able to afford it comfortably and that she has enough surplus left for other needs. . The main difference is that in a fixed rate loan, the bank bears the risk of rising future rates, while in a variable rate loan, Shikha bears the risk that future rates rise. With the exception of a lucky situation where Shikha is able to lock in to a very low fixed rate, an adjustable rate loan is a better option as he does not try to guess at future rates.

Shikha needs to know that her bank may have a better view of interest rates than she does. A good clue may lie in the price. Fixed rate loans can be more expensive than variable rate loans, if the bank believes the rates will increase. It helps banks earn more as rates rise, through the variable rate option. If the fixed rate is lower than the variable rate, the bank anticipates a drop in interest rates. It helps the bank to lock in to a higher fixed rate. It is important to know whether the fixed rate home loan is fixed for the duration of the loan or not, as most lenders offer a loan that is fixed for an initial term of 2 to 5 years and then it becomes floating.

(The content on this page is courtesy of the Center for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava, and Labdhi Mehta.)

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