HOUSING LOANS - TO FLOAT OR NOT TO FLOAT?
Interest rates in India have been rising relentlessly and home loan borrowers - both existing and potential - are a baffled lot. Those who opted for floating rates a couple of years back when interest rates were falling are now required to shell out larger sums of money (for a longer term in many cases). The potential borrowers - those who are planning to buy a house - are looking on helplessly as both the price of residential property and the housing loan rates move northwards.
Should one opt for a fixed rate or a floating rate loan? How far will the interest rates go from here? Is it wise to lock in a fixed rate when interest rates are so high? As housing loans are long-term in nature - typically 15-20 years - it's important to understand the nature of the risks involved and to evaluate the risk-reward equation - the pros and cons - of all the options.
When you opt for a floating rate loan, you expose yourself to the vagaries of interest rate movements over the entire life of the loan. The expected pay-off for bearing the interest rate risk is to benefit from a possible fall in interest rates. In case of a fixed rate loan, the risk of interest rate movements is borne by the bank, while the borrower is immune to interest rate changes (at least his cash outflows will not change during the entire loan period). However, if interest rates fall, there will be a potential loss as you will earn lesser interest on your savings (deposits) but keep paying higher interest rate on the loan. As banks have to bear the risk in case of fixed rate loans, they price in the risk and such loans are available at a premium campared to floating rates. For example, if a 15 year floating rate loan costs 10% and a fixed rate loan of same maturity is available at 12%, the 2% premium is charged by the bank to cover its risk because it is bearing the interest rate risk in case of a fixed rate.
Interest rate movements are cyclical and a period of 15-20 years is enough to see all the phases of the movement. We can possibly see two to three complete cycles with rates rising, then stabilising at higher levels before starting a downward movement, again falling for some time, then stabilising at lower levels, rising again and so on. If this is the case, ideally it should not make a difference over such a long period of time whether it is a fixed rate or a floating rate. However, it has been seen that while the banks will immediately pass on the rising costs to the borrowers, they don't show the same promptness in giving the benefits of falling interest rates. A repo rate hike as small as 25 basis points, an increase in cash reserve ratio or even a hawkish statement by a Reserve Bank official lead to rate increases of 50 to 100 basis. It is basically the inefficiency or non-transparency of the floating rate mechanism which skews the balance against the borrowers.
As it is difficult to take a call on interest rate movements over a long period of time (even the best forecasting tools cannot predict how interest rates will move over next 15 years), the decision has to be based on a trade-off - how much risk you want to take given your current stage of life (i.e. whether you are young, middle-aged, approaching retirement, etc.) and expected income pattern (i.e. whether you can absorb unexpected changes in the cash outflows). Considering the near tem outlook, it will be advisable to go for a fixed rate. As Indian economy is on a high growth trajectory and doesn't show any signs of fatigue (plus shows some signs of overheating), interest rates are expecetd to keep moving up in near future. However, if you are young and don't mind rising EMIs in the initial few years but would like to benefit from lower interest rates later, you can go for a floating rate. But keep the option to switch to a fixed rate later if required and see its cost.
As an alternative to pure fixed or floating rate loans, some banks and HFCs are also offering hybrid loans. In such loans, a part of the loan will be at a fixed rate and remaining will be floating (ideal for those who are not able to decide between fixed and floating !). Another variant is based on duration - the rate will be fixed for the first 2-3 years and will become floating afterwards. These donot make much sense to me, as anything that looks seemingly attractive will have a premium based on the bank's view on interest rates. Bankers will come up with more innovative products to further confuse the borrowers, as the interest rate scenario gets more hazy. Personlly, I will stick to the idea of fixed rate as it implies a known mothly outgo for a fixed time. No shocks.
And, as for the floating rate loans, I would like to see two changes in the mechanism to make it more meaningful. One, rates are reset at a pre-determined frequency, say every three months or six months (and not every time the bank decides to change its PLR). Two, the rates are linked to some transparent market benchmark and not the arbitrarily determined PLR - for exmaple, average of daily MIBOR over the period or yield on 10 year government bond (plus a spread). These will make the changes more predictable and transparent for the borrower.
Interest rates in India have been rising relentlessly and home loan borrowers - both existing and potential - are a baffled lot. Those who opted for floating rates a couple of years back when interest rates were falling are now required to shell out larger sums of money (for a longer term in many cases). The potential borrowers - those who are planning to buy a house - are looking on helplessly as both the price of residential property and the housing loan rates move northwards.
Should one opt for a fixed rate or a floating rate loan? How far will the interest rates go from here? Is it wise to lock in a fixed rate when interest rates are so high? As housing loans are long-term in nature - typically 15-20 years - it's important to understand the nature of the risks involved and to evaluate the risk-reward equation - the pros and cons - of all the options.
When you opt for a floating rate loan, you expose yourself to the vagaries of interest rate movements over the entire life of the loan. The expected pay-off for bearing the interest rate risk is to benefit from a possible fall in interest rates. In case of a fixed rate loan, the risk of interest rate movements is borne by the bank, while the borrower is immune to interest rate changes (at least his cash outflows will not change during the entire loan period). However, if interest rates fall, there will be a potential loss as you will earn lesser interest on your savings (deposits) but keep paying higher interest rate on the loan. As banks have to bear the risk in case of fixed rate loans, they price in the risk and such loans are available at a premium campared to floating rates. For example, if a 15 year floating rate loan costs 10% and a fixed rate loan of same maturity is available at 12%, the 2% premium is charged by the bank to cover its risk because it is bearing the interest rate risk in case of a fixed rate.
Interest rate movements are cyclical and a period of 15-20 years is enough to see all the phases of the movement. We can possibly see two to three complete cycles with rates rising, then stabilising at higher levels before starting a downward movement, again falling for some time, then stabilising at lower levels, rising again and so on. If this is the case, ideally it should not make a difference over such a long period of time whether it is a fixed rate or a floating rate. However, it has been seen that while the banks will immediately pass on the rising costs to the borrowers, they don't show the same promptness in giving the benefits of falling interest rates. A repo rate hike as small as 25 basis points, an increase in cash reserve ratio or even a hawkish statement by a Reserve Bank official lead to rate increases of 50 to 100 basis. It is basically the inefficiency or non-transparency of the floating rate mechanism which skews the balance against the borrowers.
As it is difficult to take a call on interest rate movements over a long period of time (even the best forecasting tools cannot predict how interest rates will move over next 15 years), the decision has to be based on a trade-off - how much risk you want to take given your current stage of life (i.e. whether you are young, middle-aged, approaching retirement, etc.) and expected income pattern (i.e. whether you can absorb unexpected changes in the cash outflows). Considering the near tem outlook, it will be advisable to go for a fixed rate. As Indian economy is on a high growth trajectory and doesn't show any signs of fatigue (plus shows some signs of overheating), interest rates are expecetd to keep moving up in near future. However, if you are young and don't mind rising EMIs in the initial few years but would like to benefit from lower interest rates later, you can go for a floating rate. But keep the option to switch to a fixed rate later if required and see its cost.
As an alternative to pure fixed or floating rate loans, some banks and HFCs are also offering hybrid loans. In such loans, a part of the loan will be at a fixed rate and remaining will be floating (ideal for those who are not able to decide between fixed and floating !). Another variant is based on duration - the rate will be fixed for the first 2-3 years and will become floating afterwards. These donot make much sense to me, as anything that looks seemingly attractive will have a premium based on the bank's view on interest rates. Bankers will come up with more innovative products to further confuse the borrowers, as the interest rate scenario gets more hazy. Personlly, I will stick to the idea of fixed rate as it implies a known mothly outgo for a fixed time. No shocks.
And, as for the floating rate loans, I would like to see two changes in the mechanism to make it more meaningful. One, rates are reset at a pre-determined frequency, say every three months or six months (and not every time the bank decides to change its PLR). Two, the rates are linked to some transparent market benchmark and not the arbitrarily determined PLR - for exmaple, average of daily MIBOR over the period or yield on 10 year government bond (plus a spread). These will make the changes more predictable and transparent for the borrower.
I am writing this article based on the request of Amit Shekhar who is planning to buy a house. Hope this will be useful. All the best Amit and all prospective home loan borrowers.
Posts
4 comments:
Well written sir.I am in the process of buying.Your post has given clarity of thought.Keep up the good work.
Thanks and ALL THE BEST.
Floating or fixed baffles everyone from an acclaimed economist to a layman. U hv made an apt analysis.
But I don't know of a completely fixed home loan. They are fixed for 3 yrs, 5 yrs or 10 yrs, not more.
And for a floating loan, the EMI does not change for minor variations,only the term increases
The differential between a floating and fixed loan exceeds 1%.
So I'd gone for floating (2yrs back) looking at the affordability angle too. (got to pay less initially). Now I'm regretting the decision. But my EMI is the same. Whenever I get some money, I try to prepay certain principal.
It's like a marriage decision. either way, u regret :) (lol)
Thanks Ranjan for sharing your point of view. And, the marriage analogy is good - either way, you regret !
I would like to add that what is happening now is not something you can call ' minor variations' - it's an upheaval, man. And, yes so far it has been mostly an increase in the tenure with no change in EMI. But, now EMIs have also started changing - in those cases where tenure change is no longer enough to accomodate the higher interest rates. You're lucky you have had only tenure changes.
And, thanks for intriducing the prepayment aspect - it's very wise on your part to use your ocassional surplus to prepay.
Post a Comment