subject: Fixed or Otherwise [print this page] Lets first understand what fixed rate loans mean. Very few banks offer true "fixed rate' home loans, which remain "fixed" during the entire tenure of the loan. In most cases a "fixed rate" home loan will mean that the "fixed" rate will remain fixed for 3-5 years, and at the end of which it will be re-priced to reflect the then prevailing rate. Obviously you run the risk of paying higher rates at such re-pricing and hence these loans cannot be called "fixed rate" loans by any stretch of imagination.
Most home loan consumers (more than 99%) are currently taking variable rate loans. They are taking the right decision but perhaps for the wrong reasons. Let us examine this more closely.
Currently variable interest rate loans for a 15-20 year tenure (which is the most popular loan tenure band) are available at around 7.50% p.a. The cheapest true "fixed rate" home loans for the same tenure are available from some nationalised banks at 8.50% p.a. For a 20 year tenure the EMI for a variable rate loan works out to Rs.806 per Rs.1 lakh of loan (interest rate at 7.50%) as compared to an EMI of Rs.868 for a "fixed rate" home loan at 8.50%. For most consumers this upfront benefit of lower EMI itself makes the decision easier since they do not do a detailed analysis of the risks involved in signing a variable rate loan in case the interest rate goes up.
The basic argument for paying this premium (Rs.868 per lakh minus Rs.806 per lakh = Rs.62 per lakh of loan per month) for a fixed rate loan in based on the assumption that the current round of rate decreases cannot last forever and at some point the lowest rates seen in the history of India's home loan industry will turn upwards. For a long tenure home loan, the argument goes further - taking an open-ended risk like this is not advisable.
The counters to this arguments are:
- This is not a one-time decision that you need to take as a consumer. You can always switch from a variable rate loan to a fixed rate loan in the future by paying a prepayment cost. (Of course the fixed rate available at the time of the switch will be applicable). Meanwhile you can enjoy the benefit of lower interest rate on your variable rate loan. The danger is that, by that time the prevailing fixed interest rate would have climbed much higher. Therefore the call you need to take is not whether interest rates will rise during the tenure of home loan but are they likely to rise beyond 8.50%+ p.a. rate that exists for true "fixed rate" home loans today.
-The benefit of lower variable rate is available when the principal is much higher. The cost, if any, of higher rates will apply on a lower principal. Also the tenure during which the higher interest rates will be applicable will typically be lower than contracted since most home loans are prepaid well before the contracted tenure.
-The most powerful counter argument however is much stronger. It is based on the "safety in herd" principle. Most banks have been less than transparent in passing on the benefits of reduced interest rates during the last 2-3 years helped mainly by lack of regulatory compulsion and customer inertia. Although this has been tolerated by consumers, they will rebel when interest rates start to climb (if they do) and the increased EMI starts biting into 30 lakh household budgets.
Given the above consideration we feel that, currently, fixed rate loans should be considered only where the differential in interest rate with a comparable tenure variable loan is 0.50% or lower. However this advice is based on present set of circumstances and needs to be constantly reviewed in the light of any new developments.
