Going by the last few years’ interest rate behaviour many would have easily come to a conclusion that they made a mistake by choosing the floating rate option on their home loans. Such conclusions are quite understandable since the interest rates have fluctuated between 10 and 14% over the last five years and those who had opted for a floating rate thinking that it would benefit them would have got a rude shock when their EMIs increased time and again in line with hike in policy rates.
Since the banks would pass on such hikes, not being able to bear the cost of sourcing funds, the brunt would invariably be borne by the borrowers. With inflation being almost uncontrollable fuelled by global as well as domestic economic upheavals, it has been a Herculean task for the central bank to control the inflation and manage interest rates.
A decade or so ago the concept of floating rates was not in vogue, but with the dynamics of the world changing, banks started to move away from fixed rate offerings to floating rate. This helped them to manage the volatility in their borrowing rates which kept changing along with frequent monetary policy changes.
Fixed rates work when the interest rates remain stable and when banks and financial institutions are in a position to source funds at fixed rates for longer period of time. But the problem with fixed rate loans would begin when the money supply situation eases in the economy and inflation moderates, making the RBI to offer funds at cheaper rates to banks & financial institutions, making such borrowing cheaper for them which in turn would make the lending rate to their customers lower.
How it worksTo understand this concept in simple terms – you have taken a loan on fixed rate basis at 12% for a period of 20 years which would have offered you an opportunity to maintain similar EMIs throughout your loan tenure. This option would have been beneficial only if the interest rate at the macro level (due to increase in inflationary trends forcing the RBI to increase lending rates) increases, making the loans costlier; for example banks start lending at 13% for new borrowers. In this case since your loan was locked at 12% you would be benefited compared to new borrowers. On the contrary, if the interest rates were lowered (due to conducive economic environment) you would be stuck with higher rate of interest while new borrowers would be taking loans at, perhaps, 11%.
When it comes to floating rate option the interest rates are reset in line with any significant changes in the key policy rates such as getting costlier or cheaper. The rates would get lesser when the borrowing becomes cheaper and vice versa.
Presently the banks have been permitted to source long-term funds as deposits which has started to ease the pressure on long-term lending propositions. Normally banks would be sourcing funds for a maximum tenure of 10 years which they had to manage deftly by lending long-term loans such as home loans for a tenure exceeding 20 years. This mismatch is getting resolved with some bold steps being taken by the central bank.
Given the fact that interest rates would continue to be dynamic due to the nature of growing economies there would be no guarantee that rates would remain constant for long periods of time that we actually experienced a decade ago. Banks and FIs have become cautious with such changes which affect their fund sourcing and lending strategies.
Some banks continue to offer home loans on fixed rate basis (around 11.50 to 12.50% is the prevailing rate) and the records say that only 10% of the borrowing happens under this option while 90% of customers prefer the floating rate.
Inflation levelOne has to note that the government and the RBI are working hard to bring down inflation and want to peg it under 5% and would be happy to see it stay at these levels consistently. If they collectively (government & RBI) manage to hold on to such inflation levels interest rates would surely come down to 7% which would be a dream-come-true for the policy makers and the policy followers. Hence, choosing floating rates would be more logical and recommended.
A note of caution: if you are opting for a fixed rate loan there is no guarantee that the bank or the financial institution would allow you to continue at the same rate if interest rates at the macro level rise. So one has to read the finer points of the loan agreement before signing on the dotted lines and only then seek this option.
