Fixed or floating interest rates, which one should you choose?
Borrowers often get confused between fixed and floating interest rates when applying for a personal loan. The choice of interest rate affects two critical financial aspects: the amount of EMIs payable and repayment planning.
One must, therefore, understand the difference when assessing fixed vs. floating interest rates on advances such as personal loans to decide on a suitable option.
What is fixed rate of interest?
Under a fixed lending facility, the interest is charged at a constant rate for the entire loan tenor. When opting for a fixed interest rate, the interest accrual throughout the tenor remains constant.
Borrowers can assess their fixed monthly outgoes as EMIs conveniently under a fixed rate of interest and plan their finances accordingly. However, these interest rates are usually set at a higher margin of 1 to 2% as against flexible rates.
While it can be detrimental in the case of long-term loans, borrowers of short-term advances, such as personal loans, can benefit as there are no periodic revisions and the total repayment liability remains constant.
What is floating rate of interest?
Under the floating interest rates (also known as variable rate of interest), the interest rate is subject to periodic revisions at par with changes in the repo rate, a lending benchmark set by the RBI.
Lenders add a spread or margin to the repo rate and determine the interest rate known as RLLR or Repo Linked Lending Rate. Any change in the repo rate also purports a change in the interest rate applicable to loans and advances extended to borrowers.
Although the EMIs for such loans may remain unchanged, interest rate adjustments under floating lending rate variant can extend the loan tenor due to an increase in the total repayment liability.
However, a decision regarding whether a fixed or floating interest rate is better rests on the borrower.
Given below are scenarios that can help you decide between a fixed vs. variable interest rate.
Fixed vs. floating interest rates: A comparison
It is ideal to opt for a fixed lending rate under the following circumstances:
- When borrowers wish to maintain their total repayment liability and EMIs as assessed initially and want no changes in their repayment schedule.
- If they are not ready to take risks associated with changes in market trends regarding lending rates.
Fixed rates of interest allow for better financial planning as the repayment tenor remains unchanged.
Floating rates of interest can be suitable if:
- Borrowers perceive a trend of repo rate cuts. It keeps the repayment liability in check as interest accrual reduces over time.
- They see a potential of increase in income. Opting to pre-pay your loan liability can help save significantly both on the total repayment amount and pre-payment fees.
Choosing the better alternative between fixed and floating interest rates depends on your suitability when applying for a loan. Opt for an interest rate conversion against a nominal fee payment if the benefits of one lending rate override those of the other.