Floating or fixed: Choosing right loan option crucial- FE BUREAU

Raman was in a contemplative mood. He had identified a good flat, which was close to his place of work as well as his children’s school. He had picked up a good deal and it was a ready-to-move-in house.
Now, he had to decide on the loan provider and the type of loan — floating interest rate; fixed interest rate, reset at periodic intervals; or a fixed interest lifetime loan. With the market volatile and frequent revision in interest rates taking place , Raman was in a dilemma. Since he had a clean credit history, choosing the loan provider was easy, but deciding on the type of the home loan was another matter.

This is when he decided to check with his investment advisor, who asked him for details on the loan amount, period of the loan, possibility of prepaying it, either fully or partly (every year) and the prepayment penalty amount. The advisor also explained to Raman the current economic scenario and how the interest rates movement across different interest rate scenarios would affect his loan decision.

A floating rate interest loan would mean that, as the interest rates go up, the interest being charged also goes up. This would mean that either the monthly repayment is increased or the tenure of the loan goes up. The reverse is true for declining interest rates.

In a fixed interest loan, reset at periodic intervals, the interest rate is fixed for the first 3-5 years based on the economic situation prevailing at the end of the period. The interest rates are reset either upward or downward further as decided by the loan provider (teaser loans worked on this model). In a lifelong fixed interest rate scenario, your interest is fixed at the time of sanctioning the loan for the entire tenure of the loan.

There are periods of buoyant economic activity and those of a slowdown. Interest rates change accordingly. In a period of economic growth, loans are available at cheaper rates and vice verse. Taking the above logic, the third option— the lifelong fixed interest loan — works well if the interest rates are rising and the loan is for a shorter period, say, 3-5 years. However, the monthly repayment outflow will be higher if the quantum of loan is high, which would not be suitable to all.

Say, you need a loan for R13 lakh at 11% interest for a period of 20 years. The EMI works out to be R13,418 per month. At the end of the loan tenure, you would have repaid a total sum of R32.20 lakh, including interest of R19.20 lakh.

Now, let's say you go in for a floating rate loan wherein the interest rate for the first two years was 11%, for the next three years 8% and for the balance tenure, 10%. At the end of 20 years, you would have repaid a total sum of R29.81 lakh, including interest of R16.81 lakh. You notice that there is an overall saving of R2.40 lakh in a floating rate scenario, wherein, to begin with, you had a higher rate and, as the economic environment improved, you got lower rates. However, in a rising interest rate regime, the picture will be different and the outflow could be higher.

The obvious question is: Which option should you go for? It depends on your needs. Raman is a conservative super-saver, and he would prefer a fixed interest loan, reset at predetermined intervals, with loan prepayment option. This gives him the flexibility to settle his home loan at an earlier date and also ensures that his EMI outflow does not vary with the changing interest rate. The lifelong fixed rate interest loan would be most suitable for a shorter duration, as the economy goes through highs and the lows over a period of time. In a floating rate scenario, the EMI changes as per the prevailing rates. So, either your EMI goes up or down or the period of loan varies.

Ask your friends who had used this option in 2007 and how, now, the EMI or the loan period has changed, causing regular revisits on the monthly outflow. So, before choosing the option, know what you are comfortable with. Look at various scenarios and try to understand how it will impact your cash flow. Take your time and once you decide, act on it. Having one’s own nest is an exciting feeling.

The writer is founder and managing partner Zeus WealthWays LLP