How good is fixed cum floating interest rate loan?

Borrowers always find it difficult to choose between a fixed rate loan and floating rate loan, and in recent years, they have to consider one more option -- fixed floating rate loan.

In this loan type, the interest rate is fixed for an initial period, which later gets converted to a floating one.

Let’s check out how it will impact Ramesh in the below example:

Ramesh is contemplating taking a housing loan to purchase a house. He comes across a new offering in the market with an interest rate of 8.5 per cent for the first year.

Ramesh requires Rs 11 lakh for a period of 15 years. So, he wants to know the actual cost that he will incur once the initial period is over and the manner in which his payments will be impacted.

Analysis

On the face of it, Ramesh benefits because his interest rate is fixed at 8.5 per cent for the first year. This could mean he has to pay a lower equated monthly installment (EMI) in the first year. However, he can be in for a rude shock when the loan rate is converted to a floating rate as the adjustment could lead to a sharp spike in the rate.

How does it work?

Ramesh will pay Rs 10,832 per month (at 8.5 per cent interest rate) as an EMI for the first year. And, the loan tenure is 15 years.

Year 1: When the rate remains fixed

Out of the total payment of:

EMI: Rs 1,29,984 (Rs 10,832 x 12)

Interest payment: Rs 92,048

Capital: Rs 37,936

At the end of the first year, there will be a further 14 years left on the loan. If in the meantime the loan rate has increased in the market, initial changes will be made in the EMI figure and consequent changes in the interest rate would be adjusted in the remaining tenure of the loan.

Year 2 onwards: When it moves to a floating rate

Let's assume that your floating rate is 10 to 11 per cent. In this case, Ramesh would pay an EMI of Rs 11,769 to Rs 12,416, which is still higher than the current amount.

What should you do?

Consider the impact beyond year 1 while taking the loan. If interest rate for a new loan is deliberately kept lower to attract customers, the reset could then lead to a spike in the EMI. This would mean a large discount in the first year to the prevailing interest rate and also rates that might not conform to the rising future trend of interest rates.

To sum it up: Understand the future impact of the changes before you make your decision.

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