Buying a house is one of the most memorable moments for any family. When I was a kid, I still remember a wall hanging "Home Sweet Home" in my friends and relatives house. You will not find this wall hanging these days but from the bottom of the heart, Home is still Sweet Home for all the family members. The property provides an emotional, psychological and financial support to the family. The way "Gold" act as a hedge against inflation similarly the "Property" act as a hedge against any crisis on the personal front. On the contrary, the property purchase process is one of the most complicated processes in India. The reason being, buyers are not aware of all the rules and regulations. The rules vary from state to state. For the middle class, it is inevitable to avail home loan for property purchase. Thanks to skyrocket property prices. At the same time, easy availability of credit contributed to the boom in the real estate sector. The home loan adds an additional layer of complexity to the property purchase process. At the time of the availing home loan, some decisions have a major financial impact on the borrowers. Any financial misjudgment can cost heavily to the borrower. Normally a borrower relies on the DSA or Executive of a Home Loan provider for such decisions. It's a million dollar question whether DSA or Executives are competent enough to help the borrower in arriving at a right financial decision. One such decision is related to home loan tenure. Banks insist young borrowers avail home loan for 30 years. The borrower is trapped because of lower EMI but he fails to calculate that longer home loan tenure means higher interest outflow. It increases the overall cost of the property. Thus longer home loan tenure has a major financial implication for the borrower. The home loan interest rate is another critical factor. At the macro level, it is advisable to avail home loan from market leaders. The reason being, the cost of funds for home loan providers like SBI, HDFC Ltd, ICICI Bank etc is the lowest thus benefit of lower interest rate is passed to the borrower. The reason for access to cheap funds is high CASA ratio, the scale of operations or highest credit rating/credibility. The catch 22 situation arises when the bank or HFC offer the borrower to choose between Fixed Interest Rate and Floating Interest Rate. Due to various reasons, we hate volatility and are more comfortable with stable interest rates. In other words, prima facie Fixed Interest Rate is a more preferred option if we are not aware of pros and cons of both Floating and Fixed Interest Rate. A borrower is dependent on the DSA or Bank executive to decide. It is always advisable to carry out an independent research. A borrower should take his/her own decision on fixed/floating interest rate. The reason being, the decision on interest rate has a major financial implication in the long run. Let's understand the pros a-nd cons of Fixed and Floating Interest Rate. In the last section of this post, we will discuss how a borrower should decide between fixed or floating interest home loans.
Fixed Interest Home Loan
As the name suggests, the interest rate of the home loan remains FIXED for entire home loan tenure. Though this statement is not 100% correct. Thanks to "reset clause" included in the home loan agreement by the Bank's/HFC's. I will discuss it in detail under "cons" section. Fixed interest rate home loan is more beneficial during the period of increasing/high inflation cycle.
In 2003, the floating interest home loan was available at around 8% and Fixed Interest Home Loan was also offered at 8%. In next 5 years, the floating interest rate peaked at 12.5% and fixed interest rate was offered at around 13% in 2008. I am not considering teaser home loans that were banned by RBI because of obvious reasons. The average CPI inflation increased from 3.8% in 2003-04 to 9.1% in 2008-09 (Source: Planning Commission). Therefore, if someone availed fixed interest home loan in 2003 at 8% reaped maximum benefits. I am assuming there was NO reset clause. Even today, the floating/fixed interest rates are more than 8%. Therefore, it is beneficial to avail fixed interest when the inflation is on the rise.
1. Fixed EMI: Fixed Interest home loan is beneficial for borrowers who don't have fixed source of Income. Any sharp fluctuation in interest rate is not good their financial health. A fixed EMI helps them to plan their finances in a better way.
2. A borrower can hedge the risk against interest rate movement in anticipation of a high inflation/interest cycle.
3. It is more suitable for borrowers who hate volatility in Interest Rate. For example, MCLR linked floating interest Home Loan will be highly volatile in the case of a sharp change in inflation figs or change in RBI’s stance on credit policy.
4. It is beneficial for borrowers who are nearing retirement or are in mid-40's. Any increase in interest rate does not leave any scope for increase in home loan tenure. Therefore, banks/HFC's increase Home Loan EMI. It may upset their financial calculations. Therefore, it is better to hedge risk against an increase in EMI.
1. Pre-Payment/Pre-Closure Penalty: This one of the major drawback of fixed interest home loan. Banks/HFC's may charge prepayment penalty of up to 2%. In other words, it is exit barrier for a borrower. In the case of higher interest rate, the borrower cannot shift/balance transfer home loan. Some of the banks/HFC's do not levy any penalty if the pre-payment or pre-closure is from own sources. Considering the average home loan tenure of 7-8 years in India, pre-payment penalty may force a borrower to continue with the burden of home loan. Therefore, it is advisable for a borrower to check all the terms and conditions before signing on the dotted line.
2. Reset Clause: A reset clause is a devil in the case of increasing interest rates. A bank or HFC may choose to increase interest rate in case of an increase in interest rates but may choose otherwise in case of decreasing interest rates. Most of the fixed interest rate home loans are “fixed” only for the specific period say 2 years, 3 years, 5 years or 10 years. Some home loan providers also offer Fixed Interest Rate Home Loan for FULL TENOR. To avoid any future shock, a borrower should clarify these points.
3. Higher Interest Rate: Depending on the home loan tenure, the fixed interest home loans are offered at higher interest rate compared to floating interest rate home loans.
4. Fixed Interest Home Loan is not offered by all the banks: It is not mandatory for all the banks or HFC's to offer fixed interest home loan. It might be quite surprising for you that one of the largest home loan providers, SBI does not offer fixed interest home loan to its borrowers.
Floating Interest Home Loan
Floating interest home loan is variable in nature. It is linked to the MCLR or Base Rate of the bank. In other words, the interest rate of the borrower is closely linked to the prevailing interest rate. It is more beneficial to avail floating interest home loan during the softening interest/inflation cycle. A borrower may reap benefits of lower interest rates in future.
1. Interest Rate Adjustment/Conversion: Any decrease in Base Rate or MCLR is automatically passed to the borrowers. Though, the increase in base rate or MCLR is negative for the borrowers. Besides the change in base rate/MCLR, borrowers can pay conversion fees to reduce their markup above base rate/MCLR and bring interest rate at par with new borrowers.
2. Pre-Payment/Pre-Closure Charges: As per RBI/NHB guidelines, Banks/HFC's cannot levy any penalty on pre-payment or pre-closure of Floating Interest Home Loans.
3.Lower Interest Rate compared to Fixed Interest Home Loan.
4. Financially beneficial during softening interest rates.
1. Highly Volatile: Sharp increase in interest rate might come as a shocker to borrowers. By default, the banks will increase Home Loan tenure of the borrower. From 1st April 2016, all the floating home loans are linked to MCLR. MCLR will be more volatile compared to floating interest home loans linked to base rate.
2. The Increase in EMI: Depending on the risk assessment of a bank, EMI of the borrower can be increased in case home loan tenure cannot be stretched beyond a limit. It also depends on the age of a borrower.
3.Optimization of Home Loan tax benefits is not feasible: Some of the borrowers meticulously plan the tax deductions/benefits on a home loan to take max tax advantage. It might not be feasible in case of sharp movement in the interest rate.
How to decide between Floating and Fixed Interest Home Loan?
Interest rate cycle is difficult to predict but not an impossible task. The macroeconomic indicators like inflation and interest rate movement provide a fair indication of future interest rate cycle. A borrower can keep a close eye on these indicators and also monitor credit policy of the central bank i.e. RBI. Sometimes the Govt's focus on the economic growth overrides the macroeconomic indicators and keeps the interest rates at a lower level. Besides macroeconomic indicators, international crude oil prices and Govt Bond Yield are other reliable indicators to monitor interest rate cycle.
In layman terms, if the borrower is anticipating softening of interest rates then financially it is beneficial to opt for floating interest home loan. On the other hand, if there are indications of hardening of interest rates then it is advisable to opt for fixed interest home loan. Depending on the stage of interest rate cycle, a borrower may opt for either full tenor fixed interest home loan or fixed for a specific period say 5 years.
Words of Wisdom: In my personal opinion, the difference between the interest rate of floating and fixed interest home loan is an imp indicator of future interest rates. The diff is lowest in case the home loan provider anticipates that interest rates will decrease further. The home loan provider would like to project fixed interest home loan attractive to a borrower. It is beneficial for the bank to lock-in borrower at the relatively higher interest rate in anticipation of the future drop in interest rates.
On the other hand, if home loan provider is anticipating that home loan interest rates will increase, the difference between floating and fixed interest rate will also increase. Therefore, floating interest home loan looks attractive compared to fixed interest home loan. In this case, Home Loan provider does not want a borrower to lock-in at the relatively lower interest rate in anticipation of the future increase in interest rates.
To conclude, when the banks/HFC push fixed interest home loan products to a borrower, a borrower can conclude that interest rates may decrease in future. On the contrary, if floating interest rate products are pushed hard then it implies that interest rates are nearing a bottom.
As a Borrower Be financially wise!!!