With interest rates beginning to fall, bank customers are again facing this puzzle on whether they should to go for a fixed rate loan or floating rate loan when they have to borrow. A fixed rate loan by definition has a fixed rate of interest throughout the tenure of the loan and, as such, the EMI remains constant all the while. But in the case of a floating rate loan, the interest rate can keep changing depending on the bank’s own base rate which keeps fluctuating depending on how the Reserve Bank of India’s policy rate moves.
Another benefit of a floating interest rate loan is that you can opt for keeping the EMI constant even when the interest rate is falling and try and reduce the tenure of the loan instead.
The base rate is the minimum rate at which a bank lends to its best customers. Interest rates of all loan products are fixed with a premium over this base rate. Base rates of all lenders are closely linked the policy rate, which the central bank fixes on the basis of the money supply situation in the market and various macro-economic factors like inflation, industrial growth and the external economic environment.
India’s interest rate regime has been on a downturn this year, with the Reserve Bank of India reducing its policy rates thrice so far in the first seven months of this calendar. But the outlook for the policy rate going forward may depend on a host of issues, including the monsoon rains, inflation trajectory in the economy, the pace of economic growth and how things pan out in the global economy, including the Greece crisis in Europe and a possible move to hike interest rate in the US.
Yet, the longer-term outlook for the interest rate curve looks downward. In such a situation, bank loan customers should ideally go for a floating rate loan, as a fixed rate loan may cost them more in a low interest rate environment.
While banks/NBFCs offer both options for almost every loan, they prefer it if you choose the floating rate for longer tenure debt, such as home loans. This helps them mitigate the risk of asset-liability mismatch, which may occur when they borrow short term and lend long term. That is why lenders usually charge a higher EMI for fixed rate loans. This tempts borrowers to opt for floating rate loans, as the outgo is ostensibly less.