Imagine you’re about to embark on a journey to purchase your dream home, a place where cherished memories will be made. You’ve reached the critical juncture where you need to decide on a crucial aspect of your home loan—should you opt for a fixed interest rate or take the path less predictable with a floating interest rate?
But what exactly is a floating interest rate, and why does it matter when securing your home loan? Let’s navigate through the waters of this financial choice. By the end of this article, you’ll be equipped to make an informed decision that aligns with your personal financial goals.
What is Floating Interest Rate?
When securing a home loan, one of the key decisions is choosing between a fixed interest rate or a floating interest rate. A floating interest rate, also known as a variable interest rate, is a rate that fluctuates over time based on market conditions. Unlike fixed rates, which remain constant throughout the loan tenure, floating rates are tied to a benchmark rate like the RBI’s repo rate or a bank’s internal lending rate.
Understanding how the floating interest rate works can help you choose the right home loan option that aligns with your financial goals and risk appetite.
Example of a Floating Rate
Say, you take out a home loan at a floating interest rate of 8% (Repo Rate + 2%). If the RBI increases the repo rate by 0.5%, your new interest rate will rise to 8.5%..
On the other hand, if the repo rate decreases by 0.5%, your loan interest rate will drop to 7.5%.
Since floating rates fluctuate based on market conditions, you can benefit from lower payments when interest rates decrease but must also be prepared for potential increases.
How to Calculate Floating Rate of Interest
The floating interest rate is influenced by various economic factors, such as:
Repo rate: The rate at which the central bank lends to commercial banks affects the base lending rate.
Government monetary policies: Policy changes, such as tightening or easing money supply, impact interest rates.
Inflation rate: High inflation may lead to increased interest rates, while lower inflation often results in reductions.
Fiscal deficit: A higher fiscal deficit can prompt the government to adjust rates to manage borrowing needs.
Global and foreign interest rates: International rate changes, especially in key economies, can influence domestic floating rates.
Floating Interest Rate vs Fixed Interest Rate
A floating interest rate fluctuates over time based on market conditions, as it is linked to a benchmark like the RBI’s repo rate or MCLR. This means your monthly payments can increase or decrease, depending on interest rate movements. Floating rates often start lower than fixed rates, making them a good choice when interest rates are expected to fall. However, they carry the risk of rising payments if rates increase.
On the other hand, a fixed interest rate remains constant throughout the loan tenure. But while they provide financial stability, they are usually higher than floating rates initially.
Who Should Opt for a Floating Interest Rate?
Floating rates are suitable for borrowers who:
Expect interest rates to decrease in the future
Are comfortable with market fluctuations and potential rate changes
Seek lower initial interest rates compared to fixed-rate loans
Have flexible budgets and can comfortably manage varying EMIs
When is Floating Rate Relevant?
Floating rates are relevant in the following situations:
When interest rates are expected to drop: Borrowers can opt for floating rates if they anticipate a decrease in market rates, as this can lower their interest burden over time.
For long-term loans: Since floating interest rates fluctuate, long-term borrowers may benefit from periodic rate reductions, making floating rates more cost-effective over an extended tenure.
For easier loan prepayments: Floating rate loans often come with lower or no prepayment penalties, allowing borrowers to pay off their debt faster and reduce overall interest costs.
For investment instruments: Investors can choose floating-rate investments if they expect rates to remain stable or increase, ensuring steady or rising returns.
Why Choose a Floating Interest Rate?
Market Conditions Forecasting: Imagine you have a hunch that interest rates for home loans are on a downward trajectory. By selecting a floating interest rate, you position yourself to benefit from these anticipated decreases. As the interest rate drops, the actual cost of your loan also decreases, potentially leading to significant savings over time.
Scope for Saving Money: One compelling reason to opt for a floating interest rate is that they tend to be more affordable. In general, floating rates are 1–2.5% lower than their fixed-rate counterparts offered by the same lenders. This lower interest percentage can translate into monthly savings, allowing you to allocate your funds more efficiently.
Opportunities for Unexpected Gains: Those who choose variable interest rates can capitalise on market fluctuations. If market rates dip below the base rate, your interest rate becomes lower than both fixed and base rates. This unexpected advantage aligns with the dynamic nature of financial markets, offering the possibility of saving money.
Advantages & Disadvantages of Floating Interest Rate
Factor
Advantage
Disadvantage
Interest rate
Floating rates are generally cheaper than fixed rates, leading to cost savings.
If market rates rise significantly, borrowers may end up paying more than those with fixed-rate loans.
Market volatility
Even if floating rates increase temporarily, they typically stabilise over time, minimising long-term financial impact.
In highly volatile markets, sudden spikes in interest rates can lead to short-term financial strain.
You should select a floating interest rate if you're comfortable with potential fluctuations and want to benefit from lower initial rates.
Which is better - fixed rate or floating rate?
The choice between fixed and floating interest rates depends on your risk tolerance. A fixed rate offers stability, while a floating rate can be more affordable if rates are low and you can handle fluctuations.
What does it mean to float your interest rate?
Floating your interest rate means that the rate can change periodically based on market conditions.
What is an example of a floating rate?
An example of a floating rate is a home loan with an interest rate tied to the repo rate, where changes in the repo rate directly affect the loan's interest rate.
Can you change from fixed to floating and vice-versa?
Yes, many lenders allow you to switch between fixed and floating rates, but terms and conditions may apply.
Why should you choose floating interest rate?
You should choose a floating interest rate if you expect market rates to decrease, as it can lead to lower interest costs over time. They also offer flexibility, allowing easier prepayments with little to no penalty.
How often do floating interest rates changes?
Floating interest rates change periodically based on the benchmark rate set by the lender. Typically, rates are revised quarterly, semi-annually, or annually, but they can change more frequently if market conditions fluctuate significantly.
Will my monthly EMIs change if I choose a floating interest rate?
Yes, if you choose a floating interest rate, your monthly EMIs may change depending on market fluctuations.
25 March 2025
5 mins read
Previous Post
