Everyday Money: Difference Between Floating and Fixed Rate Loans
While floating loans are cheaper and more flexible, fixed rate loans might be a better option if you want clarity on your EMI outgo
All major commercial banks and non-banking financial companies (NBFCs) offer two loan options—floating rate and fixed rate loan. A floating rate loan is linked to an external benchmark (beginning 1 October, 2019) and fluctuates as per the changing market conditions. For instance, loans linked to repo rate may change with the increase or decrease in repo rate declared in the bi-monthly policy review by the Reserve Bank of India. A fixed rate loan, on the other hand, has a fixed interest rate for fixed repayment tenure. We compare the benefits of both the options to help you choose:
Benefits of floating rate loan
Cheaper interest rate: Interest rate of floating loans is usually lower by 75-250 basis points (bps). Even if the floating rate ticks up because of the market conditions, it would be for some part of the loan period and not throughout. Besides, RBI mandating linking of floating rates to an external benchmark means that the floating rates will definitely benefit from rate cuts. Effectively, floating rate loans are cheaper over the long term in spite of the rate fluctuations.
No penalty on prepayment: When you have a surplus, you can prepay your loan. Fixed rate loans charge a penalty of 2.5-3 per cent on the outstanding principal amount whereas there are no prepayment charges on floating loans.
Benefits of fixed rate loan
EMI is fixed: In a fixed rate loan, you don't have to stay updated about the changing market conditions. On the other hand, in a floating rate loan, you can't be completely sure about your EMI outgo and may find it difficult to budget. It can be particularly difficult when rates constantly rise over a few months. The extra amount you will shell out can disturb your budget.
Cheaper in the short term: In a market where interest rates are likely to keep increasing in the future, a floating rate loan can get expensive in the medium to short term. If the interest rates have corrected and you are borrowing for a short tenure of up to 2 years, you may want to fix the rate so that you continue to pay a smaller amount.