Floating interest rate refers to the variable interest rate that changes during the duration of the loan/ debt obligation tenure. It is opposite to the fixed interest rate system. The interest rates remain the same for the entire tenure in a fixed interest rate. Most commonly, loans are acquired at both fixed and floating interest rates that are dynamically changed as per interest rate market conditions. This article covers floating interest rates, their advantages and disadvantages in detail.
What is Floating Interest Rate?
A floating rate refers to an interest rate that fluctuates with the market or is based on an index. The interest rate may change (increase or decrease) several times throughout the course of the repayment tenure.
The Reserve Bank of India sets the base rate (repo rate). The base rate is dependent on the market conditions. Furthermore, the interest rates are pegged to the base rate. The lender calculates the interest rate by adding ‘spread’ (additional interest) to the repo rate. Any change in the interest rate is passed on to the borrower and is modified to match the current interest rate on the loan.
Depending on the terms and conditions of your loan, floating rates can change on a regular basis. For instance, they can be modified every quarter, half-year, or year.
Any changes in the interest rate during the tenure of the loan will not affect the EMI amount. Instead, the tenure of the floating rate loan varies. On the other hand, the loan tenure is also reduced when the floating rate reduces. As per the RBI guidelines, lenders cannot charge a prepayment penalty in a floating rate loan.
Furthermore, financial institutions charge a lower floating interest rate in comparison to the fixed interest rate. As a result, floating rates help you save money.
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Advantages and Disadvantages of Floating Interest Rate
Following are the key advantages of floating interest rate:
- Pegged to the Repo Rate: The repo rate is the rate at which banks borrow from the Reserve Bank of India (RBI). And, floating rates on loans are directly pegged to the repo rate. Long term loans with floating interest rates are more cost-effective than fixed interest rate loans. Furthermore, lending institutions add ‘spread’ to the repo rate. Spread is an additional interest charged over and above the repo rate.
- Cheaper: Since floating rates are highly dependent on the market, they are volatile in the short term. However, in comparison to fixed interest rate loans, floating rates are cheaper. There is no maximum rate hike allowed in a floating interest regime. You will end up saving more even if the interest rate rises by 1-2% or more. As interest rates rise, the floating interest rate is generally adjusted. In other words, the monthly instalment doesn’t go up; instead, the loan’s tenure increases.
- Likewise, floating rates are re-adjusted when repo rates fall to reduce the loan tenure rather than the monthly instalment.
- No Prepayment Penalty: As per RBI guidelines, the lender cannot charge penalties on loan prepayments.
Following are some of the disadvantages of floating rate:
- Unpredictable and Inconvenient: Floating rates are unpredictable, making it difficult to plan and budget the finances. Furthermore, the changing interest rates make it difficult to keep up with the EMI payments. Therefore, floating rates lack certainty and stability in EMIs.
- Financial Planning: Since the interest rates are volatile, it becomes difficult to do financial planning. Unfavourable market conditions may lead to higher premiums and hence can become costly.
Who Should Opt for a Floating Interest Rate?
You should opt for a floating interest rate loan when you think the base rate will either remain the same or reduce over time. Under such scenarios, you will enjoy either the same rate through the loan tenure or have lesser interest to pay.
For instance, if RBI slashes the interest rate, you can enjoy the lower rates until the next revision by RBI. As a result, lower rates are more attractive for a floating interest rate loan than a fixed interest rate loan.
Furthermore, opting for a floating rate will help you make prepayments with some extra money that you hold. For example, hike in salary, cash bonus, year-end bonus, sales incentive, etc. As a result, you can repay the loan faster, and the total interest pay-out will be lesser. Thus, if you see any opportunity for higher income in the future, a floating interest rate will work out to your benefit. In other words, as your salary increases, you can repay your loan faster. Therefore, floating interest rates are lucrative when you are willing to undertake the interest rate volatility and wish to benefit from quicker loan prepayment.