Tuesday, March 17, 2009

Fixed & Floating rates: How to choose fixed & floating rates

fixed floating rates

Though not much change is expected in the near future, new borrowers would do well by going in for fixed rates.

The recent hike in interest rates of housing loans has again set borrowers (and prospective) borrowers thinking about which option to go in for. The decision to go in for the fixed interest rate option, the floating interest option, or to take the middle path is not easy to make. It has to be taken on the face of uncertainties. The costs of an error are high and so is the potential to err. One wrong judgement will entail a longterm liability and the gamble may not pay off. It is all the more important because the quantum of borrowing is large and the time period for repayment long.

As is common knowledge, in case of a fixed rate of interest, the rate of interest is decided before hand, at the time of taking the loan. The rate remains the same during the tenure of the loan irrespective of the market rates of interest. In case the interest rates goes up, the borrower still pays on the agreed lower rates of interest. In case the interest rates go down, the borrower loses as he has to pay a higher interest as compared to the market rates.

On the other hand, in case of floating rate loans, the rate of interest is linked to the market rate or a benchmark rate. For example, the prime lending rate of the bank. The rate of interest varies directly with the market rates. In case the interest rates go down, the cost of borrowing for the borrower also goes down. In case the rate of interest goes up, the cost of borrowing for the borrower also goes up. Thus, the borrower floats along with the market rates of interest and has to constantly monitor the market movement of interest rates.

In case of semi-fixed loan or semi-floating loans, one can get a flavour of both fixed as well as floating rates. A portion of the loan is treated as fixed and the balance is treated as variable or alternatively, for the first few years, the interest rate is fixed and after that period the interest rate is floating.

The change - increase or decrease - in interest rates can be passed on to the borrower either as change in amount of equated monthly instalments (EMIs) or through change in the number of instalments to be paid. Usually, the EMIs are not disturbed and the amount is adjusted through the number of instalments payable.

While taking a decision, a borrower faces a dilemma. Which option to go in for - fixed or floating rate? A risk is involved in both the cases and the borrower needs to take a conscious decision after analysing certain factors.

A retail borrower should objectively analyse the general trend in movement of interest rates. In case all interest rates have been going up over a period of time (which has been the case recently), then the general expectation is that interest rates on housing loans would also go up, and vice versa. The main factor is the time period over which the trend would continue.

Going by the present scenario, inflation rates may see an upward movement consequent to the global price rise of crude oil. An increase in inflation will have an impact on interest rates as well. Simultaneously, the adequate liquidity in the system will tend to prevent a drastic increase in interest rates. So forces on both sides would tend to have an impact on interest rates. However, the floating interest rate borrower need not panic. Interest rates won't touch alarming heights as they did in the past. Some corrections will definitely take place, and we are already witnessing them by way of increase in interest rates by some banks. For new borrowers, they may do well to lock in at the fixed rates so as to insulate themselves against the vagaries of changes in interest rates.

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