What Is The Difference Between Fixed Rate And Floating Rate?

Let us understand this concept through an example. Consider the following scenario: Since the beginning, Ravi and his family have been living in a rented home. When his father had to take a transfer because of his government job, the entire family had to relocate. All of Ravi’s schooling years and early life went like this; switching cities and homes.

When Ravi was in the 11th standard, he often used to think of having his own home. The thought of having his own home someday motivated him to work hard and earn good money. He decided that someday he would buy his own house and make his parents proud.

Fast forward 15 years, and Ravi is working and earning well in a private job. He is the vice president of sales in a big enterprise. Financially, he is now in a position where he can afford to buy a home for his family.

However, he needs some clarification about taking a home loan. Should he take a loan at a fixed rate or should he go with a floating rate of interest? So he does what most people do in any confusing situation. He searches for information about the topic on the internet.

When it comes to buying a house, many people, like Ravi, spend a lot of time deciding what would be best for them. Choosing a fixed rate or going with a floating rate. 

Firstly, you should know that the interest rate is calculated based on two very important factors.

These are:

1) The principal loan amount

2) The tenure of the home loan

Now let us try and understand what a fixed interest rate is.

What is a fixed rate?

A fixed interest rate is simply an interest rate that any borrower would have to repay in fixed and equal amounts.

The key feature of the fixed interest rate is that there are no fluctuations in it, irrespective of the market. This gives the borrower a sense of trust and certainty. Needless to say, this is a good choice for those who usually plan their budget in a practical and detailed manner.

However, you won’t be able to get any advantage if the rate of interest decreases as per market conditions. You must pay those fixed monthly payments regardless.

What is a floating rate?

As the name suggests, a floating rate can and does change as per the market conditions. For a floating rate, you will need to pay a base amount while a floating element of interest is added to your loan.

The “base rate” is simply the minimum interest rate that is set by the lender. It can be any financial institution, whether it be a bank or an NBFC. They are not allowed to lend below this base rate.

And as and when the base rate changes, so does the floating rate. The major difference between the two is that the floating rate is usually cheaper than the fixed rate of interest. However, this is not always the case. Depending upon the market conditions, the floating rate can also overtake the fixed rate at times. Thus, the floating rate is not ideal for those who like to plan everything.

Benefits of a Fixed Rate

It remains constant. If you choose to go ahead with a fixed rate, you will not have to worry about the fluctuations happening in the market. Regardless of them, it remains constant.

Your EMI amount will not change. While repaying the loan, you should pick the EMI amount that you are comfortable paying every month. That is to say, you will need to ensure that it doesn’t hamper your monthly budget.

It helps you plan your budget accurately. One of the advantages of a fixed rate is that you can plan your finances in a detailed manner. This is because you don’t have to worry about the rate of interest fluctuating constantly.

Now that we are aware of the benefits of fixed rates, let’s talk about the benefits of floating rates.

Benefits of a floating interest rate

The greatest benefit of a floating rate is that the interest rate is usually lower than the fixed rate of interest. The best part about opting for a floating rate is that if the economy performs well, you end up paying a lower interest amount. Thus, you can save a lot of your hard-earned money.

The increased interest rate that you pay is temporary.

Another advantage of a floating rate is that even though it may exceed the fixed rate of interest, that would be temporary. Because after a certain point in time, the interest rate gets lower as and when the economy stabilises.

Fixed-rate vs. floating rate: What should you choose, keeping in mind the basic differences?

If you opt for a fixed rate of interest for your home loan, then you will have to pay a fixed amount for the entire loan tenure. On the other hand, if you opt for a floating rate, then you will have to pay monthly instalments that would be lower than the fixed rate. However, in this case, the amount of EMI can change depending on how well the economy and markets are performing.

Conclusion

Depending on your needs, you can pick whichever interest rate you find convenient. For those who want to play it safe, a fixed rate would be a better option. For those who don’t mind taking a little risk, the floating rate would be a good option.

For more detail on financial topics, visit the Primal Finance website today.