Fixed vs Variable Interest Rates - How to make the Right Choice

Jagpreet, a 26-year-old Qualified Accountant earns a decent income working with a leading Edtech. He is looking forward to purchasing a new house before his marriage.

He has been scanning various loan options and has approached lenders for a home loan and had to decide between a fixed-rate loan and a floating rate. He understands the basics of Interest rates but considering that interest rates have been declining or generally constant in recent years he is not sure of which one to choose.

Are you also struggling to make the choice?? You should also know these 2 things for making the right decision: -

1) Firstly to understand what are these rates and what is the difference.

Fixed Interest Rates:? It is a rate that remains unchanged throughout the entire term of the loan or investment and interest payment is known throughout loan tenure.

Features:

• Fixed interest rates protect borrowers from rising interest rates in the market.
• Provides better stability and predictability to borrowers to plan and budget their finances effectively over the tenure of the loan.
• Generally, there are prepayment penalties - if the loan is paid before the end of the fixed term.

Variable Interest Rates: ?Also called adjustable or floating rate, is a rate that can change over time based on fluctuations in market conditions, or an underlying benchmark rate.

Features:

• Linked to benchmark rates such as the Marginal Cost of Funds Lending Rate (MCLR), the Repo Rate, or other external benchmarks specified by the Reserve Bank of India (RBI) and hence keeps changing.
• When interest rates in the market decrease, borrowers benefit from lower interest payments but rising rates would lead to higher amounts of payments or more EMIs.

2) Which one to choose now? Which is the better option Fixed or Floating Interest rates?

There is no straightforward answer to it however following factors can help you conclude the right decision

-?????? Start the Process by deciding on how much of an EMI you can afford. Predicting future interest rates is not possible, hence always compute what you can reasonably afford as an EMI irrespective of the choice you will make.

-?????? A fixed-rate home loan in which the interest rate is fixed for the tenure of the loan provides a certain cash outflow for a certain period of time. People who are looking for more certainty may want to opt for this however, it might turn out to be on the higher side, especially for a long period when the rate declines.

-?????? In a floating-rate home loan, the interest rate changes as per market interest rates over the tenure of the loan. Lenders typically adjust the tenure of the loan and keep the EMI constant in floating-rate loans. If interest rates were to fall in the future, you would benefit from a reduction in repayment tenure. If rates move up your repayment tenure can increase.

-?????? One should also know that banks may have a better view of interest rates than you. A good clue may lie in the pricing of the loan. Fixed-rate loans may be priced higher than floating-rate ones if the bank believes rates will rise. Banks earn more through the floating rate option if rates increase. If the fixed rate is priced lower than the floating rate, the bank is anticipating a fall in interest rates. This helps the bank to lock in a higher fixed rate. This may not always work but can give you a decent idea as to what to do.

-?????? The prepayment clause should always be reviewed to ensure that the Bank does not penalize you when you want to prepay.?

While there are various arguments for both of them, in my view floating rate of interest has more pros for Jagpreet primarily due to the following: -?

- Floating rates are slightly lower than fixed rates.

- As it's linked to the market sometimes EMI may decrease especially seeing that interest rates have been falling for the last few years.

- EMI tenure gets extended in case Interest rates get increased and considering Jagpreet has the age in his favor, it should be fine for him.

Hope this helps.

Do share your comments, feedback and other learnings you would like to share!