Why a floating rate home loan is better

Thinking of buying a home?

Then you have to contend with two factors: rising real estate rates and rising interest rates on home loans.

Why interest rates will rise

The Reserve Bank of India has set the trend for higher interest rates in its mid-term review of Monetary Policy (October 2005).

These are policies of the government, via its central bank, to influence the direction of the economy by affecting interest rates and money supply.

Reverse Repo
When the RBI borrows money from banks against its securities, the interest rate at which it does so is known as Reverse Repo.
In other words, this is the rate the RBI pays banks when they lend money.
This rate has gone up from 5% to 5.25%

Repo
When the RBI lends money to banks against their securities, it is known as the Repo rate.
This is what the banks pay the RBI when they borrow money.
This rate has gone up from 6% to 6.25%

This means the RBI is willing to pay more now for the money it borrows and wants a higher rate for the money it lends. This clearly signals a shift towards a higher interest rate.

• Buy or rent - which is better?

Will home loans be affected?

Certainly. If you are looking at a home loan, you can be sure that you will have to pay a higher interest rate soon.

Which brings us to what type of loan you should opt for: A fixed or a flexible interest rate loan?

If you want no surprises, you can opt for a fixed-rate loan. Here the interest rate remains constant all through the repayment tenure.

But this will come at a cost. Interest rates on fixed home loans are higher than those on floating home loans. Sure you get the certainty that home loan rates will not rise but you end up paying more for it.

The interest rate on a fixed home loan is around 1% - 1.25% higher than that for a flexible home loan.

• Problems with your home loan?

You get the loan cheaper than a fixed home loan. Currently, you will get a floating interest rate loan for around 6.75% to 7.50%. But, a fixed rate loan will go for around 9%.

So, even if the floating rate rises in the range of 7% - 8%, it still is less than the fixed rate option.

Moreover, this interest rate hike will not be for the entire tenure of the loan. Say you took a loan for 15 years. Over such a long time frame, interest rates are bound to fall.

To understand how a floating rate loan works, read Want a floating rate loan?

When the interest rate on a floating rate loan rises, you have two options.

One is to let your Equated Monthly Installment (amount you pay every month towards the repayment of the home loan) stay constant and your tenure increase.

The other is to ask for the tenure to stay constant while the EMI increases.

If you cannot manage either (a higher EMI or a longer tenure), then it is best you opt for a fixed rate loan where your tenure and EMI stays unchanged.

• Want to switch your home loan?

If you have a floating rate loan currently and want to switch to the fixed rate option, you will have to pay a switching fee.

This would range from 0.50% to 2% of the principal amount outstanding. So, for every Rs 1,00,000 principal outstanding, you would have to pay a fee ranging from Rs 500 to Rs 2,000.