Repo rate rise: Should you choose a fixed interest rate home loan?

The Reserve Bank of India (RBI) raised the repo rate in May and June by 90 basis points as inflation escalated. Two consecutive rate hikes by the RBI indicate that inflationary pressures are here to stay. Further rate hikes are expected and required to tame inflation. Following the changes in the repo, lenders have passed on the rate hikes to home loan borrowers. This has led to longer loan tenors or higher EMIs for borrowers with floating rate home loans. Only two months ago, home loan rates were trending at a decade low.

The 40 bps hike in May resulted in the lowest home loan interest rates rising from 6.8% to 7.2%. With the latest rise of 50 bps, the lowest rates will now be in the 7.3 to 7.7% range. Considering further hikes of 50-75 basis points this fiscal year, the lowest rates may rise to around 8.5%. This will impact households. With this rapid rate increase, anyone who had financed at a rock-bottom rate in the last two years may soon be staring at a hundred or more additional EMIs.

For example, for a loan of Rs 50 lakh at 7% for 20 years (240 months) has an EMI of around Rs 38,765. Assuming the same EMI with a 7.5% rate, the loan tenor will increase by nearly 23 months. At 8.5% with the same EMI, the tenor will increase by around 10 years.

Amid the current interest rate scenario, many borrowers are contemplating if they should shift to a fixed-rate loan to protect themselves against interest spikes. To help you decide, we discuss here a few crucial points for both fixed and floating rate home loans.

Interest rate

The interest rate is important in determining your equated monthly installments (EMIs). Therefore, you must understand both fixed and floating rate home loans. As the name suggests, a fixed interest rate home loan comes with a fixed interest rate for the entire tenor of the home loan. It doesn’t fluctuate as per the market trends, so it provides a sense of stability to the borrower. It helps you plan your monthly expense as the repayment amount remains unchanged.

On the other hand, the interest rate in floating rate home loans fluctuates as per the prevailing market situation. The interest rate is linked to a base rate and a floating rate. So when the base rate changes, your floating rate also revises.

Now, what is the difference between them? A fixed interest rate home loan is usually much higher than the floating rate. For example, one private bank advertises a lowest floating rate of 7.60% and a fixed rate of 12%. This means you will have to shell out a higher EMI than a floating rate home loan. Also, when the rate decreases, a fixed-rate home loan borrower cannot benefit from lower rates. The table below will give you a fair idea about the difference.

10 Lowest Floating Home Loans Rates

Bank Name Home Loan Under Rs 30 Lakh (in % pa)
Central Bank 6.85-7.30
UCO Bank 6.90-7.10
Bank of India 6.90-8.75
IOB 7.05
Canara Bank 7.05-9.30
Karur Vysya Bank 7.15-9.35
Bank of Maharashtra 7.30-8.85
Indian Bank 7.40-7.90
Punjab & Sind Bank 7.40-8.50
Union Bank of India 7.40-8.90

BANKS (Fixed rates)

Axis Bank 12
IDBI bank 9.85-10.10
Union Bank of India 11.4

Note: Fixed interest rates may be subject to a revision after a specified tenure. Rates may apply only for a definite period and change to floating after that. Data taken from the respective bank’s website as of June 17, 2022. Contributed by BankBazaar.com

Protection against inflation

With inflation numbers increasing, the cost of living is also going up. In this scenario, it makes sense to always stick to avenues that help you have more money. A fixed-rate home loan may theoretically protect you against rate volatility. However, if it is already priced well above floating rates, it won’t really help. It helps in a scenario where floating rates have risen exponentially due to inflation, rising above fixed rates. This is an improbable scenario. If you had taken a fixed-rate loan in the last 2-3 years, you would have paid a substantial premium over floating rates which fell to as low as 6.40. And in a scenario where your fixed-rate becomes lower than floating rates, your gains may still be limited since you’ve been paying a substantial premium before that point. Secondly, the floating rate may still fall after an inflation spike, but your fixed rate will remain high.

Prepayment costs

Prepayment costs refer to the amount you will incur if you want to pay off your debt faster. Depending on the lender and terms and conditions, there will be prepayment penalties on a fixed-rate home loan. Many banks charge repayment charges up to 3% of the outstanding amount. On the other hand, in a floating rate, there are no such charges of prepayment or pre-closing the loan before the tenure. There will be a small simple interest payment. It is less than fixed-rate penalties.

Refinance costs

Home loan refinancing helps you pay off your existing home loan by availing of a new home loan that offers a lower interest rate and better terms and conditions. Refinancing helps borrowers by shifting them from a higher interest rate to a lower rate of interest along with flexible repayment terms. This contributionss to their long-term savings. You can shift from floating to fixed interest rate and vice-versa. However, this conversion comes with a cost of up to 2 per cent of the total loan amount. This means that on a loan of Rs 30 lakh, you may pay as high as Rs 60,000 as conversion fees. Therefore, before availing of the refinancing facility, it makes sense to do your maths to understand how much you will have to shell out as the conversion charges and the amount of interest you will save.

When does a fixed-rate home loan work?

Home loans are typically repaid over a long period. In that period, interest rates may see several cycles. With a floating rate loan, you will get the benefit of falling rates as well as being able to pre-pay the loan without penalties. On the other hand, in an extreme inflation scenario where rates go from all-time lows to double digits, there may be short-term protection with a fixed-rate loan. Car and personal loans are examples of fixed-rate loans. They are short-term loans. Fixed or floating, there’s not going to be much difference in interest. So it doesn’t hurt to lock into a fixed rate and protect yourself against rate volatility in the short term. In some rare scenario, this may be true for home loans as well. There may be a small possibility that fixed-rate loans work for some borrowers in the short term where inflation spirals out of control and floating rates rising exponentially. But borrowers must do the math and verify this assumption. For most borrowers, it will probably not be true. In most cases, a floating rate loan with the option to pre-pay and pre-close is better.

The author is the CEO at BankBazaar.com. The views expressed are that of the author.

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