Home loans: Floating rates are better

When applying for a home loan, opting for interest rates is a cause of dilemma. Should one opt for 'floating' or 'fixed' rates of interest?

Interest rates have been fluctuating since the last 6 years, so much so that the consumer is not sure of the future.

In March 2000, the floating interest rates on home loans were about 14 per cent; later they started falling quite steeply. By the last quarter of 2003, the interest rate (floating) on home loans fell to 7 per cent.

Again in January 2007, the loan interest waves have surged to a high of around 10.5 per cent (floating rate of interest). This hike is dramatic considering that it is a jump of 3.5 per cent since the historic low of 7 per cent reached in 2003.

This uncertainty has once again raised the million-dollar question. What should a home loan consumer do? Should s/he go in for a floating rate home loan?

This could mean a home loan at a cheaper rate with an inherent risk of being hit by a huge increase in interest rates in the future.

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Or, should the home loan borrower seek the safety of a fixed rate home loan? This effectively means that s/he could be paying a huge premium today.

While the interest rates are a deciding factor in taking a home loan, we must remember that this is not a one-time decision.

Be a vigilant consumer even if you have opted for a fixed rate of interest. As a matter of practice, assess how the markets have moved in a six-month period and consider the costs and benefits of changing your decision.

Interest rate nuances

A well-informed consumer makes better choices. So, let's try and get to the nuances of the interest rates options.

A true-blue 'fixed' interest rate is one that remains fixed during the entire tenure of the loan. It should be such that the bank does not have the power to change the rate under any circumstances.

Even under fixed home loan rates banks have the right to increase loan rates despite the 'fixed' tag. The loan agreement between the home loan borrower and the bank consists of a clause that allows banks to increase even fixed rates. This clause is the reset clause in the fine print.

Very few banks offer actual true-blue fixed interest rates.

Unlike the 'fixed' interest rates on the home loans, banks can change floating interest rates if banks' cost of borrowing increases (this is happening currently and almost all banks have increased their floating home loan rates).

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So as a consumer, it makes sense to opt for 'transparent floating' interest rates on home loans.

This essentially means that the interest rates should move downward when general interest rates register a fall and move up when the general interest rates move up.

To check whether the bank offers a 'transparent floating' interest rate on home loans request for its record of benchmark rates in 2002 and 2003.

Benchmark rates are interest rates based on which banks determine the rate at which they will lend to a borrower. Generally, home loan rates increase or decrease with a corresponding change in these benchmark rates.

This data will help you gauge whether the bank has actually passed on the benefit of reduced rates to its existing consumers at the time when the lending rates had fallen rather dramatically.

Why 'transparent floating' home loan rates are better

We strongly recommend the option of 'transparent floating' interest rates on home loans. Our choice is based on certain criterion:

These loans are at least 1.5 per cent cheaper than a comparative tenure fixed rate home loan.

There is safety in numbers. Over 90 per cent of the home loan consumers opt for floating rate loans. This is a potent and large community, which the politicians can ill afford to ignore and hence a dramatic increase in rates in a short time is very unlikely.

If you go in for a transparent floating rate home loan, you also get the benefit of reducing interest rates as (not if) and when the interest rate cycle turns and commences on its downward journey.

Even if the interest rates rise in the interim, you are still a net gainer as long as they do not rise above the one per cent differential between the fixed and floating rates.

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This is because, as we have said earlier, floating home loan rates are 1.5 per cent cheaper than a comparative tenure fixed rate home loan.

We advise you to go in for a transparent floating rate loan unless, you want to play it completely safe and are willing to pay the premium (in terms of high interest rates) for the safety of a fixed home loan rate.

In any case, signing a fixed rate loan that is not a real fixed rate loan-makes no sense whatsoever (remember the reset clause).

So, float but with transparent rates.

Harsh Roongta is CEO www.apnaloan.com. He can be contacted at askharsh@apnaloan.com.