A hybrid option

Borrowers are hedging their risks by opting for a combo of fixed and floating rate loans

Once upon a time, home loan buyers were faced with the dilemma of deciding between a fixed rate loan and floating rate loan.

Depending upon your risk appetite and your perception of future interest rate movements you opted for either the fixed rate (where the rate remained fixed for the tenure of the loan) or the floating option (where interest rates varied with market rate fluctuations).

The decision was a tough one and often in retrospect it might have been the wrong one.

Now there is a third option which is gaining popularity. The hybrid loan, as it is called, is a combination of fixed and floating rates.

"We began the product because of customer queries who felt they wouldn't like to put all their eggs in one basket and basically because they were pretty confused about where interest rates were headed," says Suresh Menon, general manager, Mumbai region, HDFC.

Hybrid loans aren't a completely new concept in the housing loan business. HDFC has, in fact, been offering them for the last two years. But now more banks are jumping on the hybrid bandwagon. Organisations like PNB Housing and ICICI Bank have only just begun offering these loans.

The way the hybrid loan works is that you can chose to divide the total loan amount into two tranches which will be treated as two separate loan agreements with two interest rates "" fixed and floating.

Say you are taking a loan of Rs 20 lakh and you feel that interest rates will increase you can choose to take 60 per cent of Rs 20 lakh as a fixed rate home loan and the remaining as floating. If you are unable to take a call the division can be 50:50 and so on.

Basically the prevailing interest rate will apply to both loans, but in the event that interest rates rise, the portion under fixed rate will be your buffer. And if they fall, then you gain on the floating component and lose on the fixed.

"That's where your individual risk perception will come into play. The decision will determine whether you gain or not in the long run depending on how you perceived the market and how it actually turned out," agrees Rajiv Sabharwal, general manager, ICICI Bank Limited.

In case rates rise, you can foreclose your floating component of the loan with no pre-payment penalties; however, the same doesn't apply to a fixed rate. The standard 2 per cent pre-payment penalty will apply unless you have negotiated otherwise.

If at some point of your loan tenure your outlook on the market changes and you feel rates will head south, you can convert the fixed component into floating by paying a conversion fee of 0.5 per cent of the outstanding loan amount.

"Typically, this product works best for people who take large loans because they are more interested in hedging their risks. In that sense it is a pretty niche product, but it is available to everybody," says Menon.

Take this example. Say you take a loan for Rs 50 lakh with a 50:50 division of fixed and floating. So Rs 25 lakh will be offered to you at say 8 per cent (HDFC's current pure fixed rate), while the balance Rs 25 lakh will be offered at 7 per cent (HDFC's current floating rate) for a period of 20 years.

For the fixed rate loan, your EMI will work out Rs 20,912 and for the floating rate loan it will be Rs 19,383, taking your total monthly liability to Rs 40,295.

If interest rates rise one per cent in the tenth year, the eleventh year onwards while your tenure on the fixed rate continues to be same, the tenure on the floating rate loan component will go up by 9.5 months.

In the reverse scenario that is if there is a 1 per cent interest rate decrease, the floating rate component will cut your remaining tenure by 3.5 months. This will enable you to hedge risks.

If instead of the hybrid loan, you decide to go for the fixed interest rate loan, make sure that your loan is indeed fixed for the entire duration of the loan.

Banks such as ICICI and HDFC have put in a clause in some of their loans under which they reserve the right to amend the 'fixed' rate in the event of an 'extreme change in money market conditions'.

The problem is that bankers aren't exactly clear about what this implies. Some say it would be triggered if interest rates went up by more than 4 per cent. Others disagree with that view.

"We're not talking about 1 per cent changes, it's more like a situation of hyper inflation and that is a scenario we're not expecting anytime in the horizon," says Sabharwal.

HDFC offers both a pure fixed rate product and also one which is linked to money market conditions. The fixed rate product with the money market option (as it's called) is being offered at a lower rate than the pure fixed rate product.

On the former, the interest rate ranges from 7.75- 8 per cent and on the latter, the range (which is determined by the loan amount) is 8 per cent to 8.5 per cent.

So before you settle comfortably into thinking that you've protected yourself, read the fine print to find out whether the rate will stay constant for the entire duration.