When choosing a home loan, one of the most important factors is the interest rate. This plays a major role in determining your EMI. There are two major types of interest rates, which are thee fixed interest rate and the variable interest rate. In order to choose the right kind of interest rate for your home loan, it is important to understand what each one means and their pros and cons.
Fixed Vs Variable Interest Rate
What is fixed interest rate?
Fixed interest rate results in equal and fixed monthly instalments throughout the tenure of the loan. The interest rate does not change with changes in economic conditions or banking regulations. In the beginning stages of the loan, the EMIs will be used to pay back the interest while in the later stages it will be used to service the principal amount. Even within the fixed interest rate, there are options to fix the interest rate for specific time periods (such as for 3 or 10 years). This comes with the lender’s right to reset the interest at any point in time.
Pros of fixed interest rate
These are the advantages of a fixed interest rate:
- You have fixed EMIs which make it easier to budget your finances as you know exactly how much you will have to pay every month
- The interest rate does not become higher if the market or banking regulations result in higher interest rates
Cons of fixed interest rate
Some of the disadvantages of a fixed interest rate are:
- Fixed interest rate has a higher rate of interest
- If economic conditions result in lower interest rates, the interest rates will not change on your home loan
- The fixed rate at the start of the loan could be reset after a specified time period (depends on the lender). If so, the new interest rate could be higher than the initial one.
When to choose a fixed interest rate
You could choose a fixed interest rate in the following scenarios:
- If you think that interest rates will increase in the years to come, then it would be wise to lock your home loan with a fixed interest rate at the current rate of interest.
- If home loan interest rates have declined at present, then it would be a good time to choose a fixed interest rate.
- The EMI that you have to pay with a fixed rate of interest does not exceed 25% to 30% of your salary and the balance is sufficient to manage your household and other expenses.
What is a variable interest rate?
Variable rate of interest is also called a floating interest rate. This interest rate fluctuates along with the market index/conditions or banking regulations. This depends on the base rate that is offered by the lender or their benchmark rate. The interest rate gets revised or reset when there is a change in the base rate. It is also reset at specified intervals which could be calendar periods or your loan anniversary.
Pros of variable interest rate
These are the advantages of a variable interest rate:
- The rate of interest is lower making loans with a variable interest rate cheaper than other loans.
- Lower interest rate translates to lower EMIs which means more money for household expenses in the short term and more savings in the long term.
- Changes in market conditions that bring down interest rates will result in even lower rates of interest and lower EMIs.
- Lenders may adjust the tenure of the loan by extending it instead of increasing the EMI in order to avoid a negative impact to your cashflow because of the frequent revisions. However, you could request for your EMI to be adjusted instead of the tenure.
Cons of variable interest rate
Some of the disadvantages of a variable interest rate are:
- If changes in the market conditions result in higher interest rates, then your EMI also becomes higher.
- If EMIs become higher, your monthly budget becomes unpredictable, making it more difficult to plan your finances ahead of time.
When to choose a fixed interest rate
A fixed interest rate can be selected in the following scenarios:
- If you foresee that interest rates will fall in future
- If you want to accumulate savings in the short term
Now that you know what each kind of interest rate means and the pros and cons, it is best to compare home loan interest rates for all banks and then decide which one is best suited to your requirements, budget, and lifestyle, both for the short term and long term.
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