Availing a home loan for purchasing a residential property is an expensive affair and can be a trying process. However, before availing a home loan, there needs to be some research and preparation that has to be undertaken before you are ready to select and avail a home loan. This involves researching the prevailing market conditions and interest rates to determine a favorable time to avail of home loans. You also need to research the lending options available to you to decide which options would suit you in terms of tenure, the quantum of money, the interest rate, the type of interest rate, etc.
This is where we come to the type of interest rate which is a significant factor that influences our selection of a home loan when the choices are presented to us. When you go through the lending options presented, the type of interest can go a long way in determining the quantum of your financial outlay towards the repayment of home loan. This article seeks to explain to you the concept of floating interest rates and its benefits.
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What is a floating interest rate on home loans?
The interest rate on home loans are of two types
- The fixed interest rate
- The floating interest rate
Floating interest is the type of interest that changes in response to the changes in the prevailing market conditions and overall interest rates in the economy. It is also called the Variable interest rate for the variable fluctuations it shows in the face of change in market conditions or market index.
- Floating interest rates are subject to change or revision every time the market condition or prevailing interest rate is revised in response to the needs of the economy.
- Home loans that have floating home loan rates have a base interest rate pegged at a level that has a floating element added to such rate.
- As the base rate fluctuates, the floating element added to this base rate makes the floating interest rate and such rate reflects the margin of fluctuation by which the base rate has changed. The floating rate is the interest rate at which the borrower has to make interest payments.
For instance (simple example), a borrower avails a home loan of Rs 100,000 at a rate where the base rate is 3% and there is a floating element of 3%. This means that the borrower has to pay interest at the rate of 6% which means the interest for the year will be Rs 6000. Next year when the base rate is revised or changed to 2.5%, the borrower has to pay interest at the rate of 5.5% which means the interest payable has reduced to Rs. 5500.
Thus, if the year after that, the base rate again changes to 4%, the borrower has to pay interest at the rate of 7%. Thus, the interest payable becomes Rs. 7000. There can be an increase or decrease or boh in the interest rate under the floating interest rate option during the tenure of a home loan.
Benefits of Floating Interest Rate
Floating interest rates have benefits that are the following:
- When a borrower wants to avail of a home with lower introductory interest rates, s/he selects a lending option with floating interest rates because floating interest rates are usually lower than fixed interest rates. Thus, the borrower can for some time repay the loan amount at a lower rate of interest.
For instance, the borrower avails a loan with a floating interest rate at 11% p.a. On the other hand, the fixed interest rate on offer would be a few percentage points higher than the floating rate like 13 or 14%.
- A home loan availed at a floating rate of interest is beneficial to a borrower when such borrower avails the loan when the prevailing interest rates are low. This is because even though floating interest rates may be revised to a higher percentage point if the prevailing rates are changed, such change is not permanent. It can very well be revised to a lower percentage point if the prevailing interest rate is lowered. This yields benefits to the home loan borrower in the form of lower monthly payments made towards the repayment of the loan amount, thus saving him or her money.
- If the borrower can foresee a significant increase in his or her income in the future and has availed a home loan at a time when the prevailing interest rates are low, then the borrower can prepay the loan amount with excess money, cutting short the loan tenure to enjoy the gains made in income in the future without worrying about the loan anymore.
Drawbacks of floating interest rate
- Floating interest rates are susceptible to change and if you were to avail a home loan with a floating interest rate at a time when the prevailing interest rates are high and are estimated to rise further, your financial outlay towards the repayment of the loan amount is bound to be high and rise even further.
- Floating interest rates are an uncertain species that are prone to change as the market conditions and prevailing interest rates fluctuate. Thus, a borrower has no sense of certainty and stability when it comes to availing a home loan with a floating interest rate because such a rate could change next quarter in light of the alterations of the prevailing interest rates that are used as a reference for the floating rates.
The type of interest rates on home loans is a significant factor that determines the financial outlay of a borrower towards the repayment of a loan amount. Whether fixed interest rates or floating interest rates, each have their benefits and drawbacks. An informed borrower needs to weigh these benefits and drawbacks to pick the option that is beneficial to the borrower. Coupled with a favorable interest rate, loan tenure, and loan quantum, the right type of interest rate can lead to significant savings in terms of money and in certain cases even time when prepayment of the loan amount allows the borrower to cut short the tenure of the home loan.