Financing a purchase with an ideal loan requires thorough knowledge of various aspects. One of these is the interest rates regime. Interest rates determine the affordability of a loan. Therefore, paying attention to the types of interest rates is crucial. Lending institutions vary widely in their exposure to interest-rate risk. They offer two lending rates – fixed and floating interest rates – that impact current home loan interest rates, the loan EMI (Equated Monthly Instalment) amount, and the repayment plan.
Here is the comparison between the two that borrowers should understand before finalizing a loan.
What is a Fixed Interest Rate?
This type of interest rate implies obtaining a loan at a fixed interest rate that remains the same for the entire loan term. Resultant, the EMI during the loan repayment term remains equal.
There are variants available for fixed interest rates. Lenders may offer a loan at a fixed rate for a certain period, say two or three years, during the tenure. The borrower can negotiate for the lock-in period to fix the interest rate for a specific period.
What is a Floating Interest Rate?
Floating interest rates, also known as adjusted rates, can fluctuate during the loan tenure as they are linked to the lender’s benchmark rate. These lending rates are synced with the changing market conditions and repo rates.
Generally, lenders reset floating interest rates at specified intervals, like quarterly, half-yearly, or annually. Also, it can be unique for different customers. If the market rate changes during the reset cycle or applicable review period, loan rates also be reset – increased or decreased as the case may be.
Two vital components of floating rates are the index and the spread. While the index indicates interest rates, the spread indicates the additional fee added to the loan cost by the lender to cover credit risk, profit markup, etc.
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Understanding the Differences Between the Two
Floating interest rates are generally lower than fixed rates. Since the lending rate remains constant throughout the loan tenure and the lender cannot change interest rates, fixed rates are usually a notch higher than floating rates. Floating-rate loans benefit customers with repo rate cuts. Generally, floating lending rates benefit with zero prepayment penalty. This advantage is not offered with fixed interest rates. Lenders allow fixed-rate loan prepayments under certain conditions and are subject to penalties.
– Sense of Certainty with Preplanning
Fixed rates give borrowers a sense of certainty with the loan EMI commitments and the total interest outgo as they know their monthly obligations right from the time of taking the loan. It helps borrowers to gain confidence to plan their finances. A loan eligibility calculator can help home buyers to get the answer to ‘how much home loan can I get‘ at what interest rate? It helps them to plan the repayment schedule.
– Best Suitability Scenarios
Customers prefer Fixed Interest Rates in the following scenarios –
- Ideally, borrowers prefer fixed interest rate loans if they can comfortably repay the same loan EMI during the entire loan tenure. Experts suggest choosing a loan tenure with an EMI of less than 25-30% of their monthly income. It is a practice to ensure that loan EMIs can be paid without delay.
- If borrowers perceive a rising interest rate scenario in the future, they can lock in funds against current home loan interest rates.
- If the borrower wants to remain disciplined towards their debt repayments and prefers to plan their finances, a fixed interest rate loan can work for them better.
Consider Floating Interest Rates in the following scenarios –
- Floating interest rates are preferred when the base rate is expected to reduce over time and remain constant. It results in either decreased interest outflow or the same interest cost.
- If borrowers are looking for small savings on loan interest costs, floating-rate loans can be the preference as they are set marginally at a lower rate than fixed-rate loans.
Thus, individuals can look at both lending rates’ positive and negative aspects and decide accordingly. Following the age-centric approach, borrowers in their forties prefer fixed-rate loans as they can feel secure paying the same EMIs without any surprises due to market changes. Borrowers in their twenties may be ready to take risks as they have enough time to repay the loan, especially home loans. They may consider a floating lending rate.
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