Fixed versus floating: How to choose your home loan

"Buy land, they're not making it anymore," said author Mark Twain. While this observation may certainly be correct, paying for the land is a totally different subject.

The various payment options for that dream home of yours are not as simple as they seem. And even if you narrow down on your choice of preference, there may still be other factors beyond your grasp.

"Buying a house involves a series of decisions which can have an impact on your life for years, or even decades," according to an HDFC Bank official, who wished not to be named. The decision to rent-or-buy a house is the first.

Once you come down on the 'buy' decision, short-listing the perfect home for your family is the next decision. Then comes the hard choices. Paying for that dream house of yours, especially if you need to take a loan to pay for your adobe. And then comes the crucial decision to go for a "fixed or floating interest rate" for your home loan. Considering the high cost of homes in major metros of India, this decision has an impact on your financials and, hence, requires careful consideration.

So what is the difference between the two types of loans? And how does a home loan seeker decide which one is best suitable for him or her?

In a fixed rate loan, the interest rate is fixed at the time of taking the home loan. Opting for a fixed rate home loan gives you a sense of stability or certainty in your financial planning since you know what your repayments will be right from the time of taking the loan, giving you the confidence to budget accurately and plan your finances.

"Fixed rate home loans are usually bit costlier than floating rates but it helps to fix the monthly repayment obligations," says Shaji Varghese, ED & business head, PNB Housing. It protects you from interest rate volatility and fluctuations in EMIs unlike in floating rates and enables you to plan your financial outflow much better.

The other counterpart is the floating home loan rate. Also referred to as 'adjustable-rate home loan', these loans are linked to the lender's benchmark rate, which, in turn, moves in sync with the market interest rate. "If there is a change in the benchmark rate, the interest rate on the loan also changes proportionately," according to HDFC Bank.

The interest rate on such loans is reset at specified intervals like every quarter or in the first or second half of a financial year or could be unique to each customer depending upon the date of the first disbursement of his home loan.

Another alternative is that your loan reset could also be linked to your loan anniversary. If there has been a change in the market rates during the review period, your rates too would be reset higher or lower as the case may be.

"Floating rate home loans are ideal if the loan tenure is longer and is effectively cheaper than fixed rates with the benefit of rate movement passed on," says Varghese.

However, please note that in loan rate resets, it is usually the tenure of the loan that gets re-adjusted to account for the changed interest rate. "If the rate increases, your remaining loan tenure would be extended and vice-versa," says HDFC Bank official. This is done to avoid frequent revisions to your EMI which could impact your cash flow. But if you so desire, you may request the lender to revise your EMI instead of the loan tenure.

Experts say that a fixed home loan is typically 1-1.25% higher than the floating rate equivalent.

"While there are no prepayment charges for floating rate home loans, lenders often charge a penalty on prepayment of fixed rate home loans if it's a balance transfer," Varghese informs.

However, be aware that you may not always get the options that you want.

"Given that the repo rate is nearing its historical lows, many home loan applicants would be tempted to opt for fixed-rate home loans. However, very few lenders offer fixed rate home loans for the entire tenure," says Ratan Choudhary - head of home loans, Paisabazaar.com. Most lenders usually offer a mixed home loan rate where the interest rate remains fixed for a predetermined period, say the first 2, 3 or 5 years of the loan tenure, after which the floating rates come into effect.

In the case of banks and housing finance companies offering fixed rate home loans, they usually charge a higher interest rate for the fixed rate home loan to cover their own interest rate risk.

If you are still unsure about which kind of housing loan is suitable for you, opt for a combination loan which is partly fixed and part floating. This is especially suitable for you if you have other loan repayments presently and your cash flows have been planned to meet your loan obligations for the first 3-5 years; during this term, you can opt for a fixed rate. After this phase, you can opt for the floating option for the balance term of the housing loan.

Even in the case of mixed-rate home loans, the interest rate for a fixed-rate period is usually higher than loans sanctioned on floating rates, experts point out.

So how does one make the choice between fixed or floating loans for your home purchase?

Home loan applicants should carefully compare interest rates of fixed and mixed rate home loans with those charged on floating rate home loans, say experts.

"Those who predict home loan rates to rise significantly in the near future can go for fixed or mixed rate home loans. In case their interest rate predictions go wrong, they can switch their home loans to the floating rates by paying a switching/conversion fee or transfer their loan to another lender at a lower interest rate," notes Choudhary.

Your credit score and your payments

"Those who maintain a high credit score by maintaining financial discipline are rewarded by banks and home finance companies," says Hrushikesh Mehta, Country Manager – India, ClearScore. Some lenders are already offering home loans at a lower interest rate to individuals with a score of 780 or more.

This translates into significant savings given that home loans have long tenures. "Your credit score is clearly more than just a number. It has become a reflection of your financial discipline which is now being rewarded with tangible financial benefits, Mehta explains.