Fixed Rate loan are loans where the rates remain constant throughout the loan period while for floating rate loans the rates are linked to market conditions and may be changed periodically. Floating rates may be linked to the base rate, inflation or other parameters; each bank may choose its own methodology to fix this base rate. These rates have to be declared by the bank each quarter.
Common sense says if you expect the rates to rise then you borrow at a fixed rate so that you can lock in your loan at a lower rate and if the rates are expected to fall then you borrow at floating rates so that you can benefit from the falling rates.
Are Rates Really Fixed for the Loan Tenure?
While both fixed and floating rates have their advantages and disadvantages we are not going to discuss that as the focus is to understand the true nature of fixed loan rates. Fixed loan rates are generally priced higher that floating rate loans.
Most banks have the Force Majeure (superior force/ chance occurrence/unavoidable accident) clause in the fixed loan agreement; as per this clause the bank may change the rates as it deems to be suitable depending on the market conditions or as per its internal policies. Banks may specify a period of 3 to 5 years after which they are allowed to change the interest rate. Some banks fix a regular interval of 3 to 5 years after which they will review the rates; this means that every 3-5 years the rates are reviewed while some may do it if the conditions so warrant. Most banks however keep this clause in the agreement to keep themselves safe.
When the applicant signs the loan agreement he/she may overlook this clause which allows a bank the discretion the revise the loan rate. Thus if you plan take a fixed loan rate @ 11% while choosing to overlook the floating rate loan @ 10.% thinking that you will be paying the same EMI throughout the term as the interest rate will not change then you need think again.
When a borrower chooses a fixed rate loan he or she is choosing a loan that is more expensive (when compared to floating rate loans) as he or she is looking for the certainty that comes with it. The borrower presumes that he/she will be able to plan his finances better as the EMI remains constant. Thus if the rates are revised (generally in the upward direction) he/she may be left unprepared to bear the additional burden per month. Not only does the borrower feels cheated the primary reason for taking an expensive loan is defeated but he/she may also have to make considerable modifications to his/her monthly budget to pay the higher installments.
What should the borrower do?
While as a borrower you may feel cheated if you are caught unaware with an increased EMI burden, the lender cannot be faulted. They put the clause in the loan agreement, whether fine print or in bold the clause is there. As a borrower it is your responsibility to read and understand all aspects before signing the agreement.
So if you are taking a loan or planning to take one, check about the reset clause in the agreement and be prepared for the additional burden that you may have to shoulder during the loan tenure. Though it may be rare but there might be financial institutions that may offer loans that are truly fixed without any reset clause; so if you are really sure that you want only fixed rate loan you could opt for them.
Either ways it’s better to be sure about what you are signing. Whether it’s a floating or a fixed rate loan; each has its advantages. Be sure about other terms and conditions too.
The author is Co-Founder & Director, CreditVidya.