When it comes to loans, one of the most important decisions borrowers must make is choosing between floating vs. fixed interest rates. The interest rate choice can significantly impact the total cost of the loan and the borrower’s financial stability.
In this article, we will look at both fixed and floating interest rates and examine their respective advantages and disadvantages. We will also compare the two types to understand the difference between fixed and floating interest rates to help you determine which option might be best for you.
What is a Fixed Interest Rate?
A fixed interest rate is one where the rate of interest remains the same throughout the entire loan tenure. When you opt for a fixed-rate loan, the interest rate and the periodic payments (EMIs) are set at the beginning and do not change irrespective of rate changes in the market.
Now, before we compare floating vs. fixed interest rates, let us quickly go through the advantages and disadvantages of fixed rates.
Advantages of a Fixed Interest Rate
A fixed interest rate can be highly advantageous for borrowers. Here is a quick overview of some of its key benefits.
- Budgeting and financial management are a lot easier with a fixed interest rate since borrowers can accurately predict their equated monthly instalments.
- Borrowers are protected from rate increases since fixed interest rates will continue to remain constant throughout the loan term regardless of the changes.
- Fixed-interest-rate loans are straightforward and less complex to understand compared to floating-interest-rate loans.
Disadvantages of a Fixed Interest Rate
Despite the advantages of a fixed rate, there are certain drawbacks that borrowers need to be aware of. Let us quickly go through some of the key disadvantages associated with this particular type of interest rate.
- Financial institutions often set fixed interest rates higher than floating interest rates for most types of loans.
- Borrowers will not benefit from rate decreases since fixed interest rates do not change at any point during the loan tenure.
What is a Floating Interest Rate?
Also known as a variable or adjustable rate, a floating interest rate is one that changes over the course of the loan tenure. Floating rates are based on a benchmark rate and can increase or decrease depending on how the benchmark moves.
Depending on the financial institution, the benchmark rate for floating interest rates can either be the repo rate or the Marginal Cost of Lending Rate (MCLR). In the case of any change in the floating rate, the amount of interest borrowers pay on a loan will also vary.
Now that you are aware of the meaning of a floating interest rate, let us explore some of its advantages and disadvantages.
Advantages of a Floating Interest Rate
Borrowers can enjoy a host of benefits by opting for a floating rate. Here is a quick overview of some of the key advantages.
- Financial institutions often set floating interest rates slightly lower than fixed rates, which could potentially lead to savings, at least during the initial phase.
- If the benchmark rate remains the same or decreases, borrowers opting for floating interest rates could end up paying less interest over the life of the loan.
- Some floating-rate loans come with a cap on rate increases, which prevents the interest from becoming highly unaffordable.
Disadvantages of a Floating Interest Rate
A floating interest rate also has its own share of disadvantages. This is one of the many similarities between fixed and floating interest rates. Let us look at some of the key disadvantages of this rate type.
- The monthly payments may vary if there is any change in the floating interest rate, making budgeting a lot more challenging for borrowers.
- If there is a significant rise in the interest rate, borrowers may end up paying substantially more interest over the life of the loan.
Difference Between Fixed and Floating Interest Rates
Here is a tabulated comparison of fixed vs. floating interest rates, outlining the key differences between these two loan rate types.
| Particulars | Fixed Interest Rate | Floating Interest Rate |
| Rate Stability | Remains constant throughout the loan term | Fluctuates based on market conditions |
| Initial Rate | Generally higher than floating interest rates | Often starts lower than fixed rates |
| Monthly Payments | Consistent and predictable | Can vary over time |
| Benchmark Rate Changes | Have no impact on fixed rates | Directly affects the floating interest rate |
| Budgeting | Easier due to consistent and predictable payments | More challenging due to potential changes in the interest rate |
| Risk Level | Lower risk for borrowers | Higher risk for borrowers |
| Loan Suitability | Better for longer-term loans | Often preferred for shorter-term loans |
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Fixed or Floating Interest Rate: Which is Better?
Now that you have seen the difference between fixed and floating interest rates, which of the two should you choose? Here is a quick guide to help you out.
A fixed interest rate could be the ideal choice if you prefer stability and predictable payments and believe that interest rates will rise in the future. Furthermore, you can also consider opting for a fixed rate if you have a low tolerance for risk or if you plan to take long-term loans such as a home loan, where the chances of rate increases are high.
A floating interest rate, on the other hand, could be suitable if you can tolerate risk and have a flexible budget that allows you to handle some uncertainty in your loan payments. You can also consider opting for this interest rate type if you plan to take on a short-term loan or believe that the interest rates will continue to remain low or decrease in the future.
Conclusion
The choice between floating vs. fixed interest rates is a significant decision with long-lasting financial implications. When deciding between the two interest rate types, always make sure to consider a wide range of factors such as your financial situation, risk tolerance, and market conditions. This will allow you to make well-informed decisions that align with your financial objectives.
FAQs
Can I switch from a fixed interest rate to a floating interest rate during my loan term?
Yes. Many lending institutions allow you to switch from a fixed to a floating rate and vice versa during your loan tenure. However, even if they do not offer the facility, you can still make the switch by refinancing your loan with a different financial institution.
How often are floating interest rates revised?
Floating interest rates are reviewed and revised every quarter. However, you can expect a change in floating rates only if there is a change in the benchmark rate that they are based on.
Which benchmark rate are floating interest rates based on?
In India, floating interest rates are based on either of two benchmark rates – the repo rate or the Marginal Cost of Lending Rate (MCLR).
Do floating interest rates always start lower than fixed interest rates?
Usually, floating interest rates tend to be slightly lower than fixed interest rates. However, this is not always the norm. In fact, the initial floating rate depends on current market conditions and the lender’s policies.
Do all loans offer fixed interest rates?
Yes. Indian financial institutions offer fixed interest rates as default for almost all types of loans.
