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Best Answer To Floating Vs Fixed Interest Rate Debate

You are well aware of the 'floating interest rate' home loans. These are quite commonly available option, wherein the interest rate is linked to a reference rate of the particular bank... presently MCLR (or Marginal Cost Lending Rate). As and when this reference rate changes, the interest on your home loan too will change accordingly.

In addition, banks also sometimes offer 'fixed interest rate' home loans. In such loans the interest rate is fixed, typically for a specified period — normally for 2 to 5 years. 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.

(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 as they deem fit. Ideally, such a clause should not be accepted.) 

The specifics of each loan would, of course, differ from bank to bank.

Among the two, floating rate loans are cheaper. The fixed interest rate loans would normally be about 1% to 2% costlier than 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 in the past have suffered extreme financial distress whenever the interest rate cycle turned adverse.

So, how do you solve this dilemma of fixed vs floating rate home loan?

As mentioned earlier, floating rate loans are comparatively cheaper. Moreover, the rates are "probably" at the peak or near peak levels. 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 less expensive.

floating-or-fixed-interest-rate

But "risk" is rather a qualitative aspect.

And, sometimes people have exaggerated fear of risk.

So how do you 'rationally' determine your 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 lifetime of your loan. 

If you have a fixed rate loan, you can always prepay and switch to a cheaper fixed rate or a floating rate loan (assuming 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.

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

(Note: You would, of course, have to suitably consider the costs involved in switching.)

[By the way: Step Up Your Loan EMIs For Mind-Boggling Savings]

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

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