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

In Part 1 of this post, we explored the various types of home loans available in the market in terms of the applicability of interest rates and considered the dilemma of Fixed vs Floating rate home loan.

As discussed, floating rate loans are comparatively the cheapest. Moreover, the rates are "probably" at the peak or near peak levels. With multiple efforts being made to cool down inflation, it is possible that rates may go down in the future if these efforts succeed. Hence, getting tied to a fixed rate today may not be a good idea.

Also, RBI has been taking steps from time to time to address the concerns of the floating-rate borrowers regarding banks not readily passing on the benefit of rate reduction to them. (It has been observed that banks tend to promptly raise the interest rates. However, they are often reluctant to reduce them for the existing borrowers while at the same time wooing new customers with lower rates.) 

However, we cannot totally ignore the risk of rise in interest rates and opt for a floating rate loan merely because it is the cheapest.

But "risk" is rather a qualitative aspect. And sometimes people have exaggerated fear of risk. So how does one ‘rationally’ determine his or her risk appetite and accordingly make the right choice?

Financial prudence suggests that your total EMI outgo — for all loans put together including the proposed home loan — should not be more than 45-50% of your total monthly take-home pay. This, in financial parlance, is referred to as Debt-to-Income (or DTI) ratio.

Therefore, if your DTI at current interest rates is already around this mark, any hike in the interest rates in future is likely to push you into the danger zone. Hence, it would be safer to opt for the fixed-rate loan. 

Only when your DTI is less than 30-35% and you have the cushion and the capacity to absorb the risk of higher interest rates, should you consider a floating-rate loan. 

More importantly however, you must remember that making a choice between fixed and floating rate is not a once-in-a-lifetime decision that would hold good for next 10-20 years. Many changes will happen in the interim. As such, you must be prepared and make at least 2-3 switches during the loan’s lifetime. 

If you have a fixed rate loan, you can always prepay and switch to a cheaper or a floating rate loan if in future the interest rates fall or your DTI comes down. Or if you had earlier opted for a floating rate loan, you can always switch to fixed-rate later if the interest rates start becoming too expensive. (You would, of course, have to suitably consider the costs involved in switching.)

It may, however, be noted that while almost all banks are willing to lend at floating interest rates, fixed interest home loans are offered by only a few of them. Therefore, you will have to hunt a bit harder to get a suitable fixed rate loan.

In short, your DTI is the touchstone to determine which type of loan is good for you. Rest all is noise and you would do well to ignore it.

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