When shopping for a new loan, you will come across terms like “fixed rate of interest” and “adjustable rate of interest.” Understanding these concepts, whether for a home loan or a personal loan, will help you make an informed decision about which type of interest rate is best for you, taking your financial circumstances and repayment abilities into account. This essay will explain all you need to know about these two terms.
What Is a Fixed Interest Rate?
A fixed interest rate indicates that your interest rate will remain constant during the life of your loan. Even if bank lending rates or the repo rates of the Reserve Bank of India fluctuate, they remain constant (RBI). EMIs (equivalent monthly installments) are consistent during the time that these lenders provide fixed-rate loans for the first few years, and then convert to variable-rate loans.
Benefits of Fixed Interest Rate
The following are the benefits of a stable interest rate based on several characteristics:
- The interest rate remains constant during the period of the loan and is unaffected by market conditions.
- Because the interest rate does not vary over time, your EMI remains constant, making it easier to manage your monthly budget as well as long-term financial savings or investments.
Drawbacks of Fixed Interest Rate
Some of the downsides of a set interest rate are as follows:
- The fixed interest rate is typically 1% to 2.5% higher than the variable interest rate offered by a bank or non-banking financing institution (NBFC).
- Even if the fixed interest rate reduces as a consequence of a government or Reserve Bank of India (RBI) decision, it would have no effect on loans taken out at the previous interest rate. Even if the interest rate is cut, the borrower is required to continue making payments at a higher rate.
- A fixed rate of interest is frequently only effective for a few years before being adjusted to match the current rate.
Why choose a Fixed Interest Rate?
These are some of the circumstances in which a fixed rate of interest may be beneficial to you.
- You desire a fixed repayment schedule and are OK with the current interest rate. You should keep your monthly payment to no more than 30% of your net monthly profits.
- You foresee an increase in interest rates in the future and want to ensure that your interest payment does not get any higher than it is now. In this situation, the fixed interest rate can be used to lock in the lender’s current interest rate.
- In situations where interest rates have declined and are likely to remain low for a few years.
What Is a Floating Interest Rate?
A floating interest rate changes in response to market conditions. The interest rate will be calculated using a base rate plus a floating element, so if the base rate changes, so will the floating rate.
Benefits of a Floating Interest Rate
Variable interest rates provide the following benefits:
- Fixed interest rates are frequently set at 1% to 2.5% lower than floating interest rates offered by the same institution.
- Variable interest rates offered by a bank or non-banking financing organization are usually lower than fixed rates offered to consumers. As a consequence, even if the floating interest rate rises, it may still be lower than the previously provided fixed interest rate.
- If the variable interest rate exceeds the fixed interest rate, it will not be for the life of the loan. There is a potential that the floating rates will fall after a specific amount of time.
Drawbacks of Floating Interest Rate
Variable interest rates have the following drawbacks:
- Because floating interest rates fluctuate, the monthly installments for a specific loan amount will alter during the course of the loan.
- Because of the unpredictable monthly installments, a loan with a changing interest rate is exceedingly difficult to budget.
- You may be compelled to pay more than you are comfortable spending because this interest rate option does not allow for a predetermined payback date. As a result, you may find yourself with fewer finances and no financial strategy.
Why choose a Floating Interest Rate?
These are some of the situations in which a changing interest rate may be helpful to you.
- When there are credible indications that interest rates may decline in the near future.
- This type of interest rate is often appropriate for people who lack market expertise and hence prefer to stick to market rates.