All you need to know about fixed and floating interest rates

If there is one long-term goal that most Indians share, it is buying a home. Watching this dream become a reality can be overwhelming - emotionally and financially. Home loans, taken often to own a house, come with interest rates that easily run into lakhs. Hence, a thorough understanding of interest rates is essential for making a financially prudent choice.

There are two types of interest rates to choose from - fixed and floating interest rates.

Here are a few vital details to help homeowners make an informed decision.

What are fixed interest rates?

As the name suggests, fixed interest rates remain fixed throughout the loan tenure. The rate is predetermined and is not affected by market conditions or broader economic factors, offering predictability and stability.

Let's look at the pros and cons of fixed interest rates.

Pros of fixed interest rates

• Easy mechanism: First-time home buyers may find it difficult to understand the intricacies of market trends and their impact on interest rates. Fixed interest rates are easier to understand and manage because of their straightforward approach.
• Mental peace: Borrowing can be a stressful experience. The indifference of fixed interest rates to market and economic uncertainties offers peace of mind.
• Budgeting ease: When the interest rate is fixed, the Equated Monthly Instalment (EMI) amount can easily be ascertained using a home loan repayment calculator. Fixed and known expenses are easier to manage and budget for.

Cons of fixed interest rates

• Higher rates: Because the lender assumes a certain degree of risk by locking the interest rate, fixed interest rates are usually 1% to 2.5% higher than floating interest rates. This translates to a relatively higher borrowing cost.
• Inability to gain from falling rates: The fixed nature of a fixed interest rate is a double-edged sword. While it can help save costs significantly when the market interest rates are rising, the inability to capitalise on falling interest rates can prove costly.
• Prepayment penalties: Most lenders who offer fixed-interest rate loans often impose prepayment penalties to discourage borrowers from foreclosing on the loan. This limits the possibility of paying off the loan early and becoming debt-free. While this is a common practice, some banks do not levy any prepayment charges on fixed-interest rate loans if the loan is repaid with personal funds.
• Refinancing challenges: Refinancing the loan to harness falling interest rates may be time-consuming and costly.

Now that you understand the meaning, advantages and disadvantages of fixed interest rates, let's move on to floating interest rates.

What are floating interest rates?

A floating interest rate is not steady. It is linked to the lender's benchmark rate, which moves in tune with the market interest rate. The changes in these rates lead to fluctuations in the floating interest rate. The floating interest rate is also known as an adjustable interest rate.

The lender resets the interest rate at periodic intervals to reflect the changes in market rates. These can be in calendar periods such as quarterly or half-yearly. Alternatively, they can also be customised as per each borrower. Either way, the lender reserves the right to decide the reset schedules.

Although the reset increases or decreases the loan tenure as per market scenarios, borrowers can request changes in the EMI amount instead of the loan tenure. They can also choose a combination of both. This flexibility was extended to borrowers by the Reserve Bank of India (RBI) in 2023. Further, RBI also allows switching from a floating to a fixed interest rate arrangement.

Let's look at the pros and cons of floating interest rates.

3 pros of floating interest rates

1. Lower rates: At the outset, floating interest rates are lower than fixed interest rates. There is also a possibility of further decline, whichthat results in substantial long term savings.
2. Ability to gain from falling interest rates: The positive correlation between the floating rate and market rate allows capitalising on falling interest rates, resulting in lower EMI costs.
3. Prepayment flexibility: Unlike fixed-interest rate loans, floating-interest rate loans allow loan prepayments, increasing borrowers' flexibility.

3 cons of floating interest rates

1. Financial planning challenges: Planning for finances becomes difficult due to the fluctuating nature of the interest rate. The disparity in the EMI amount across the tenure can cause a great deal of inconvenience while estimating the long-term borrowing cost.
2. Possibility of higher rates: The rise in the market rate directly leads to a rise in the floating interest rate, thereby leading to a higher repayment amount.
3. Market expertise: Understanding market trends to anticipate future rates is important for benefitting from floating interest rates. Thus, such rates may not be suitable for every borrower.

Difference between fixed and floating interest rates at a glance

Choosing between fixed and floating interest rates

To decide on a specific type of interest, homeowners must carefully review the pros and cons of each option. Additionally, they must also consider the following points:

• Risk appetite: As a borrower, having a fair idea of the risk tolerance level is essential to avoid any financial shocks. A fixed interest rate can be ideal if seeking predictability from the loan matters. However, a floating rate can make more sense if there is financial bandwidth to cope with potential rate fluctuations.>

• Loan tenure: Short-term loans are unlikely to get drastically affected by interest rate fluctuations, making a floating rate a better option. However, a fixed rate may be better if the loan tenure is long, owing to its predictability and stability.

• Age: Given their predictable nature, mid-aged or older borrowers may find fixed interest rates better. Conversely, young borrowers with a higher risk appetite may want to try floating interest rates for potential cost savings.

Both fixed and floating interest rates each come with their own set of pros and cons. Homeowners must make a choice only after carefully assessing their budget, needs, risk appetite, market knowledge and other vital factors.