Ideally, there are two kinds of interest rate calculation methods to arrive at the interest amount that will be charged on most retail loans, be it education loan, car loan or home loan: fixed interest rate and floating interest rate. Choosing between the two can be confusing considering the burden of interest payment that you will have to bear if you make a wrong choice.
To make an informed decision, you can look at the how the two methods are different and what factors can impact them.
What is fixed interest rate?
As the name suggests, the interest rate will remain unchanged throughout a set period. This period could be the complete tenure of the home loan or a few years depending on the contract.
The advantage of this method is that with a fixed interest rate set, the EMIs (equated monthly installments) to be paid for the entire tenure will also be decided in advance, making it easier for borrower to calculate his/her budget required for repayment.
What is floating interest rate?
It is in contrast with the fixed rate method as the interest rate will fluctuate throughout the term of the loan. The rate will move upwards or downwards in accordance with the marginal cost of funds-based lending rate (MCLR) set by the bank, which in turn depends on the changes in repo rate by the Reserve Bank of India (RBI).
The RBI periodically revises the repo rate based on the economic conditions of the country, global factors and its monetary policy.
The method has been known to help borrowers save on overall interest amount paid over the tenure when compared to fixed rate, as interest rates fluctuate.
How to choose?
Fixed interest rates are ideally preferred by borrowers, as it helps protect against fluctuations which can cause instability in calculating budget needed to make repayments.
If you can manage the fluctuations in payments and you anticipate a fall in the interest rates in the future, floating interest rate method could help you save on interest payment.
Ideally, if you have a salaried income and your proposed EMI comes to less than 30 percent of your monthly salary, you can consider it safe to stick to a fixed interest rate methodology. Monthly outgoes in the floating rate method is difficult to anticipate as banks have their own calculations on how they revise their MCLR (though largely based on market rates).
So, unless you have an expertise in interest rate cycle fluctuations, it can become unpredictable.
Also, Indian banks may start linking retail loans like home loans to external benchmark rate (repo rate) rather than the MCLR. SBI has already linked savings bank deposits and short-term loans to repo rate from 1 May. This may be followed for other retail loans as well, making floating interest rates prone to more frequent fluctuations to reflect the changes in the economy.
Finally, the choice between the methodology is a personal one as it depends on one's ability to take the risk which will impact your monthly financial needs and unanticipated emergencies.
Some banks follow a hybrid system wherein you can reset your fixed interest rate with that of a floating interest rate. Make sure to read the terms and conditions in the loan document carefully before you agree to anything.