Loan Basics: Fixed or flexible rate home loans?

But first, here is the lowdown to help you understand the options available

Lending rates have fallen notably over the past one to two years. If you have been looking to buy a home, it is no doubt a good time to lock into attractive rates now. But after lowering its key policy rate by 200 basis points since January 2015, the RBI chose to hold rates in the recent monetary policy. In fact, given the recent uptick in inflation, the possibility of rate hike by the US Fed, and growing concerns on fiscal deficit on the domestic front, the falling rate cycle could well start to reverse over the coming year or two.

Hence, the million dollar question is whether a home loan borrower should go for one of the cheapest rates under floating rate option or lock into fixed rates to tide over rate increases over the coming year or two.

Back to basics

Before we analyse the options, let us understand how they work. Floating rate loans are essentially linked to a benchmark rate, which moves up and down depending on the interest rate movement in the economy. Hence, since January 2015, in line with the RBI’s rate cut, bank lending rates too have fallen sharply by nearly 180 basis points on new loans.

Under pure fixed rate loans, the interest charged to you is fixed at the time of availing the loan and is not tweaked unless the agreement stipulates certain conditions under which banks can tweak lending rates.

There is also a third, dual-rate option, offered by a few banks and housing finance companies (HFCs). Under this, the lending rates are fixed for a specific period initially, and then moved to floating rate.

So which of the three options should you go for now?

Floating rate loans score

Ideally, when interest rates are at a peak, the choice is seemingly clear. Rather than lock into fixed rates for the long run, borrowers prefer to go for floating rate loans, benefiting from the subsequent fall in lending rates over the ensuing years. But when rates bottom out, as is the case now, borrowers may favour fixed rate loans to shield themselves from rate increases in the near future.

But the choice is not as cut and dry. Floating rate loans are still a better option now, due to several reasons.

One, a home loan is a very long-term product.Given that interest rates tend to go up and down across cycles over a period of time, locking into pure fixed interest rate loans now could cost you dear later on.

For instance, between 2012 and 2013, SBI was offering home loans at 10.1-10.15 per cent interest rate under the floating rate option. In the subsequent months, the rate did go up to 10.3-10.5 per cent.

But borrowers who locked into fixed rate loans then would have lost out on the sharp fall in lending rates in the last two to three years all the way down to 8.35-8.4 per cent. Fixed rate home loans, in 2013 ranged between 11 and 12 per cent.

Two, banks or HFCs usually charge a premium for the predictability offered by fixed rate loans. ICICI Bank, for instance, charges 9.85 to 10.10 per cent for loans above ₹30 lakh (full tenure fixed). This is more than a percentage point above the bank’s floating rate at 8.7 per cent. Hence, locking into pure fixed rate loan for a very long term at such a premium can be a losing proposition later on.

Even if your priority is predictability in your monthly pay-outs, consider fixed rate home loans only if they are not too steep when compared to floating rates.

Meanwhile, under the dual rate scheme, since interest rate is fixed for specified initial years, it can shield you from rate increases in the near future. ICICI Bank, for instance, offers dual rate home loan at 8.7 per cent rate (same as its floating rate) for 2-3 years, after which it becomes floating rate. Rates can increase any time after the next two to three years. Hence opting for a dual rate scheme may not be very different from choosing a floating rate scheme right now. Also, banks could tinker with floating rates (marginal cuts) in the coming months.

The bottom line

Given that fixed rate loans command a steep premium for their predictability, floating rate loans still are a better bet for home loan borrowers. For loans up to ₹75 lakh, Central Bank of India and Union Bank of India offer 8.3 per cent loan rate. Many other banks are also providing home loans at competitive rates for borrowers with highest credit score.

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