I took a floating rate home loan three years ago. The prevailing rate of interest is 6.75%, but I am told this could soon go up as interest rates are moving up. Should I switch to a fixed rate home loan now? That way I can avoid the hike in rates.
–Name withheld on request
(Query answered by Raj Khosla is Managing Director at MyMoneyMantra.com)
The key difference between fixed and floating rate loans is who bears the interest rate risk. In a floating rate loan, the borrower bears the risk if rates move up and gets rewarded when they decline. In a fixed rate loan the lender bears the risk. To compensate for this risk, lenders charge 75-100 basis points higher interest on fixed rate loans.
The prevailing rate for floating rate loans is about 6.5-7%, while fixed rate loans charge 7.5-7.9%.
It is true that home loan rates may go up in the coming months. The prevailing rates are very low and if the RBI hikes interest rates to control inflation, home loan rates will obviously go up. So it might make sense to shift to a fixed rate home loan now.
But before you switch, calculate how much you stand to gain from switching to a fixed rate loan. As mentioned earlier, fixed rate loans charge a higher interest, so your equated monthly instalments (EMIs) will go up after the switch. If the difference is more than 100 basis points, it may not result in any real savings for you because floating home loan rates may not go up by that much. Keep in mind that you will also have to shell out processing fee and other refinance charges when you switch to a new loan.
Most importantly, read the fine print very carefully when you make the switch. Many loans are only quasi fixed rate home loans, where the rate is fixed for initial 2-5 years after which they become floating rate loans.
Interest rates may be headed upwards in this inflationary scenario, but home loans are long-term contracts and ultimately interest rates are likely to moderate when inflation cools down.
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