Floating Rate of Interest: Overview and Detailed Explanation
While making any financial decision regarding loans, it is very necessary to have knowledge about the types of interest rates.
There are two types of interest rates named as Floating Rate of Interest and Fixed Rate of Interest.
A wise financial planner must analyze both types of rate of interest before taking a financial decision.
What is Floating Rate of Interest?
A floating rate of interest is a rate of interest which keeps on changing over the duration of loan tenure due to market conditions.
These loans consist of two parameters known as the prime rate (Base rate) and a floating constituent. Any change caused in prime rate due to market conditions also causes changes in the floating rates.
Let’s take an example,
Mr. Harshad wants to borrow 4,00,000 Rs for his business and thus he gets a floating rate loan at 6% Prime rate plus 4 % floating element. Thus his total interest will be 10%.
Any change caused by the base rate will also cause a change in the overall rate.
This means if the prime rate goes up, the overall rate will also go up and if the prime rate goes down then the overall rate will also go down.
The advantage of this to Mr. Harshad:
After taking the loan, even if the prime rate goes down, he will be saved from overpaying for the loan.
The advantage of this to the bank :
The bank will be saved from losing money even if the prime rate increases after giving a loan to Mr. Harshad.
How floating rate home loan is different than home loans in fixed Interest?
Now it’s possible to get your dream house by taking a loan. However, it is very much important that you do a better analysis of which interest rates options will suit you the best.
Let’s understand fixed and floating interest rates.
A fixed interest rate is a rate of interest which remains static over the duration of the loan tenure whereas the floating interest rates keep on changing due to market fluctuations.
A Fixed interest rate will be higher than a floating interest rate.
If the floating interest rate is 8.75% and fixed interest is 9.5%, and you have taken a loan of 3000000 Rs for a tenure of 25 years.
EMIs to be paid according to the floating interest rate will be 24,664 Rs.
EMIs to be paid according to the fixed interest rate will be 26,211 Rs.
As you can see fixed loans consists of a higher interest rate than floating rate loans, thus if you take floating rate loans, you will be able to save 1,547 Rs per month, which will be really effective in the long term.
However, it is very much necessary that the market conditions don’t lead to an increase in the floating interest rate as compared to the fixed interest rate for a longer period of time.
As the floating rates depend on market fluctuations, then even though if the floating rate rises above the fixed interest rates, still it might be for a shorter period of time, as the market has the power to lower the floating rates below the fixed rates.
If you have set aside a part of your money which you will use to pay the monthly installments, then the fixed rate interest will be suitable as the interest rate will not go high as it may go in floating home loans due to market fluctuations and thus you will not be forced to compromise your set budget.
Majority of the people take the home loans having the features of floating interest rates however, you must analyze properly regarding which kind of the interest rate loan will be convenient for you. One should study all the pros and cons before taking a decision.
Can fixed rate loans be switched to floating rate loans?
It is possible to change a fixed rate loan to a floating rate loan in your loan tenure. However, switching will cost you a small fee which can be anywhere from 1 to 2 %.
It is also possible to change from a floating rate loan to a fixed rate loan.
There is also a provision of changing a higher interest floating rate loan to lower interest floating loan and the charges for changing can be between 0.5% to 1.0%
Even in terms of fixed rate loan, one can switch from higher interest fixed loan to lower interest fixed loan.