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Best answer to Fixed vs Floating Rate Loan conundrum (Part 1 of 2)

In terms of the type of interest rates, you will come across broadly three kinds of home loans, namely:

1. Floating interest rate home loan: This is the most commonly available option wherein the interest rate is linked to the bank’s Base Rate. As and when the base rate changes (which may happen as often as every quarter), the interest on your home loan too will change accordingly.

2. Short-tenure fixed rate home loan: In order to attract customers, banks offer the so-called ‘teaser’ loans wherein a low fixed rate is applicable for an initial period — normally for 2 to 5 years — and thereafter it may (a) either be converted into a normal floating rate loan or (b) the interest may be reset for another 2-5 years.

3. Long-tenure fixed rate home loan: In such loans the interest rate is ‘generally’ fixed for either the entire loan tenure or at least for 7-10 years. (Beware! Banks are known to add a fine print that in case the conditions become too adverse, they retain the right to increase the rate. Ideally, such a clause should not be accepted.) 

The specifics of the scheme would, of course, differ from bank to bank.

Among the three, floating rate loans are the cheapest. The short-tenure fixed loans would normally be about 0.25% to 2% costlier than floating rate loans, while the long-tenure fixed loans are the most expensive…at around 2-4% more than the comparable floating rate loans. This is but natural. As long as you bear the risk of interest rate movements, the rates will be low. However, if the bank has to bear that risk it will charge a higher rate.

The lower interest makes the floating rate loans the first choice for any borrower; especially given the fact that the loan amount runs into many lakhs. As such, even 1-2% lesser rate translates into huge savings.

Nevertheless, many people are risk averse and hence not comfortable with the uncertainty in interest rates, especially when the loan runs over 1-2 decades. This is a very pertinent apprehension and a serious threat indeed. Many people suffered extreme financial distress when the interest rates shot up from around 7-7.5% levels to 12-12.5% in a short span from 2003-04 to 2006-07... and have remained at elevated levels.

So, how do you solve this dilemma of fixed vs floating rate home loan? See Part 2 of this post tomorrow for the answer...

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