Floating vs. fixed interest rates - Which one to choose?

There may be some big ticket expenses - like buying a home, purchasing your dream car, or taking an extended international vacation - that you cannot pay for upfront, out of pocket. The reason is because these experiences or items cost lakhs or crores of rupees, and paying for them upfront can take out a major chunk of your savings.

For expenses like these, there are always loans that you can avail from banks and financial institutions. But before you avail a loan, you need to be aware three key parameters -

• The amount of money you wish to borrow
• The period over which you need to repay the funds
• The interest rate

Of this, the first two are quite easy to figure out. But the last factor - interest rates - need a bit more understanding. That’s because they can be of two types.

What are the two types of interest rates offered on loans in India?

All major banks and non-banking financial companies (NBFCs) typically offer two kinds of interest rates, namely -

• Fixed interest rates
• Floating interest rates

A fixed interest rate is pretty much what the name indicates. The interest rate in this case is predetermined when you avail the loan, and it remains the same throughout the repayment tenure. So, you know well in advance what the EMIs will be during the entire repayment period.

A floating rate of interest, on the other hand, is subject to change based on the financial market. Each quarter, the Reserve Bank of India revisits and may revise the repo rates in the country. The repo rate is simply the rate at which commercial banks borrow money from the RBI.

Based on changes to the base rate, the interest rates on your loan will also fluctuate if you have availed a loan with a floating interest rate. So, you will not have a predetermined interest rate during the tenure of the loan.

Since a fixed interest rate comes with a greater degree of certainty, it is typically a bit higher than a floating interest rate. The margin of difference between fixed and floating interest rates is typically 1% to 2.5%.

How do fixed interest rates work?

Fixed interest rates are easy enough to understand. Let’s take up an example to see what the repayment particulars would be for a loan with a fixed rate of interest.

Assume you have borrowed Rs. 50 lakhs at a fixed interest rate of 8%. And say you want to repay this loan over a period of 10 years. In that case, your monthly EMI would come out to be around Rs. 60,664.

So, for each month over the course of the 10-year period, you need to pay Rs. 60,664 as your EMI. Neither the repayment tenure nor the EMI will change.

How do floating interest rates work?

Floating interest rates depend on the base rate and the RBI’s policy changes. But apart from this, many other factors also affect these rates of interest, such as -

• The rate of inflation
• The country’s fiscal deficit
• The international interest rates
• Other monetary policies of the government

So, if you avail a 10-year loan, it is fairly impossible to predict what the interest rates will be over the repayment tenure. This makes the calculations a bit tougher. But to make things easier for themselves and for you - the borrower - here’s what banks and NBFCs do if you avail a loan with a floating interest rate.

They keep the EMI of the loan constant, and adjust the tenure of the loan according to changes in the economic factors listed above. So, if the floating interest rate increases, the repayment tenure will also correspondingly increase. And if the floating interest rate during a quarter decreases, the repayment tenure also reduces accordingly.

This makes financial planning easy for the borrower, because the EMI is known upfront. It is only the tenure of the loan that will vary. So, even if you avail a loan with a floating interest rate, you can focus on the EMI and check if it is within your budget. You should be able to pay your EMIs conveniently without compromising on your other essentials.

Also, the unique advantage of loans with floating interest rates is that they do not come with any prepayment charges. This means you can foreclose your loan if you get a bonus, come into an inheritance, or receive any lump sum amount.

Which kind of interest rates should you choose?

Now that you know how fixed and floating rates of interest work, you may be unsure of what option to choose. Each type of interest rate comes with its own upsides and downsides.

Let’s check out the scenarios under which you should choose each kind of interest rate.

Choose a loan with a fixed rate of interest if -

• You expect the market to be more volatile and the interest rates to rise in the future
• You wish to have a specific repayment tenure
• You are able to get a low fixed rate of interest when you apply for a loan

Choose a loan with a floating rate of interest if -

• You expect the interest rates to fall in the future
• You are comfortable with changing loan repayment tenures
• You wish to prepay your loan at some point in the future

Conclusion

So, this sums up the key details about fixed and floating interest rates, and when it makes sense to choose each of these options. Making the right choice is important because it will determine how easy or hard it is for you to repay your loan in the future. If you are unable to pay your EMIs, you will have to pay penalties, and the bank may take possession of any collateral you may have put up.

So, to avoid these scenarios, weigh your options and make the right decisions when you avail your loan. In some cases, it is possible to switch from fixed to floating rates or vice versa. But you will have to pay an additional fee for the same.