A checklist on fixed-cum-floating loans.
There are different types of loans available for individuals and the choice has widened in recent times. In housing, there are loans with a fixed rate of interest for an initial period and after this, the rate turns into a floating one. The initial fixed rate of interest is deliberately kept low to encourage more people to move towards such loans. Even though the concept is good, some factors might make the offering unsuitable for your requirements. Here are some of these that can create a problem for the borrower over the course of the loan, so these need attention.
LONG-TERM IMPACT
A housing loan is a long-term loan which can run for 10-15 years. The period for which the interest rate is fixed on the offering has to be seen in the context of the time period of the loan. Many borrowers tend to just look at the fixed rate of interest and decide, because this seems a better rate, but this needs to be considered properly. For example, if the loan period is 10 years and the interest rate is fixed for the first three years, then this is a significant proportion, because nearly a third of the time period of the loan is accounted for. On the other hand, if the interest rate is fixed for a year, while the loan is for 15 years, then this is less significant. In such situations, the impact in the latter years may wipe out the gains of the earlier period.
BASE IMPACT IMPORTANT
The base impact for the purpose of the loan is a very important factor. With loans that are floating in nature, the initial rate is the starting point for all future changes. This means if a person has a starting rate of 9.5 per cent on a floating rate loan and then the rate increases by 0.5 per cent, then this will rise from 9.5 per cent to 10 per cent. On the other hand, when it comes to the issue of the fixed floating loan, the base rate for the calculation of the future interest in terms of the floating rate might be hugely different from the initial fixed rate. This is because the floating rate is linked to the benchmark prime lending rate (PLR). So if the initial fixed rate is, say, 9 per cent and the floating rate is 100 basis points lower than the PLR, which might be 12 per cent, then there is a sudden difference in the base. This can cause a large difference in the cost, which can suddenly jump, causing problems with the repayments.
AFFORDABILITY
The main factor to be considered in this type of loan that has a fixed and then a floating element is affordability for the borrower. The initial rate is usually kept lower to attract the customer to make the loan look affordable but some time down the line, the situation could be completely different and this can cause payment problems for the individual.
For example, consider a borrower who has taken a loan of Rs 15 lakh for 15 years at a first-year interest rate of 8 per cent. In this case, the equated monthly installment (EMI), which is the regular payment to be made each month, will come to Rs 14,335. At the end of the first year, when the fixed payments expire, the total amount repaid will be Rs 172,017. Out of this figure, the interest component will be Rs 118,049 and the principal component is Rs 53,968.
In case the interest rate at the end of the year then resets to, say, 11 per cent, then in such a situation there will be a new working for the purpose of the EMI calculation. A new figure will then become the EMI. Assuming the other conditions remain the same, then the EMI will jump to Rs 16,905 for the remaining 14 years. The figure is Rs 16,462 for a 10.5 per cent rate and Rs 16,025 for a 10 per cent interest rate. For various loans, the figure will be different, depending on the loan amount and the extent of change and so, both these factors need to be considered.
Hence, benchmark rate is low at that point of time. Movements in the intervening change and hence both these factors need to be considered.
SPECIFIC BENEFIT
There is also the fact that in order to ensure interest rates remain low at the time of the move to the floating rate loan it is important that the benchmark rate is low at that specific point of time. Movements in the intervening period have no impact, so there could be a situation whereby the borrower ends up with a higher level of rates when the switch is made and was unable to benefit from the low rates that prevailed from the time of taking the loan to the time of the switch.
The author is a certified financial planner
