In mortgage lending, the nagging question remains: should the borrower opt for fixed interest rates or opt for floating rates?
The decision to choose between a variable rate home loan and a fixed rate home loan has always been an important decision for borrowers. This topic has been widely discussed and if you search on google you will get some information about it. Having said that, you need a good perspective. First, let’s clear up the basics.
The variable rate means that the interest rate you pay now is based on the current rate environment. Thereafter, as interest rates in the economy rise or fall, the rate you pay will rise or fall accordingly.
Hence the name ‘floating’, that is to say that it floats with a reference reference. A fixed rate home loan is a tricky term. Although from the name it looks like the interest rate is fixed, there may be a fine print that the loan provider can increase the rate at any given time, triggered by a development.
This can be referred to as a fixed or variable rate home loan, where the interest rate is not as fluctuating as the variable rate, but can fluctuate under certain conditions. Then there is the fixed rate loan, which can be described as a good fixed rate loan or fixed rate fixed rate, provided you go through the document or consult a legal professional.
From the point of view of the lender, which would be a bank or an NBFC, it would be more comfortable to offer a lower interest rate than the fixed rate for a variable rate loan, because when the interest rates will increase, which will happen because the economy goes through cycles, they can increase your rate.
In a fixed rate loan, in particular a fixed rate loan, the provider is blocked on the contracted interest rate. Therefore, in a fixed rate loan, from their own margin perspective, they would prefer to set the rate on the higher side.
Borrower’s point of view
Now the big question is, from your perspective (i.e. the borrower), which one should you choose? If your loan is for a short term, say five years, the variable rate is better because you get a lower rate to start with.
Keep in mind that interest rates can go up. Even then, since the term is not too long and economic cycles take a long time to unfold, you are expected to pay a lower rate for a greater portion of the term of your loan. at the fixed rate. Currently, banks only offer variable rate loans and do not have a fixed rate EMI because the spread is large.
That is, fixed rate loans are at a much higher rate than variable rate loans and it does not make sense to offer them to customers. NBFCs, on the other hand, offer both, fixed and floating. This helps you assess where you will break even if interest rates were to rise.
The flip side of the coin is that if the fixed rate loan is supposedly fixed and not really fixed, you may feel like you are buying peace of mind, assuming that the IMEs weren’t going up, but we never know.
Now, if your loan is long term and you start with a variable rate, the interest rate cycle can reverse and you could end up paying as much as you would for a fixed rate loan. If this happens, you can switch to a fixed rate loan so you know for sure what you will end up paying. However, there would be fees / charges applicable for the change. But if the loan amount is not too small, it is worth it. Nowadays, information is easily accessible online; When the rate cycle reverses after, say, a year or two, you can track fixed rates between providers and optimize them by changing them.
A change in the rules for variable rate loans was made about a year ago. The RBI circular of September 2019 stipulated that all new floating rate loans offered by banks from October 2019 must be priced against an external benchmark.
A pet peeve of bank lending customers, and rightly so, was that banks quickly raise lending rates when interest rates rise, but slow to cut when rates fall. The options for a bank using external benchmarks are the RBI Repo Rate or the 3 Month / 6 Month Treasury Bill Yield. It has also been indicated that the interest rate below the external benchmark will be reset at least once every three months. An external benchmark is an index whose setting is not decided or influenced by the bank.
For example, the repo rate, that is to say the rate at which the RBI lends to banks for a day, is decided by the RBI, therefore external. With external benchmarking, the rate transmission will be faster on both sides, i.e. on the upside as well as on the downside.
The spread maintained by the banks is currently on the rise; with the pension rate at 4% and the lowest rate at 6.75% and most rates above 7%. The RBI circular stated that, although banks are free to decide the deviation from the external benchmark, “the credit risk premium can only change when the credit rating of the borrower undergoes a substantial change, as agreed in the loan agreement. Banks protect their margins. If interest rates were to increase in the future, at the same spread, the rate would be that much higher.
Interest rate cycles will move for a long time, and no one can time them.
On the contrary, when rates actually move, you can compare options between fixed and floating, for a fee. From now on, a floating option is best as the rates are lower with a bank offering 6.75%. You come with the advantage of a low rate and you are aware that it can go up, instead of being under the illusion of a so-called fixed rate loan.
(The Writer is a Corporate Debt Markets Trainer and Author)