Fixed vs Floating Interest Rate – Which i Better for Your Loan?

With the increasing demands and inflation we are moving towards financing our needs and necessities on EMIs (you can calculate your EMI using our EMI Calculator) instead of buying by paying all the money at once. But it is crucial to understand how the interest rate on loans works. As there could be fixed or floating interest rates on EMIs, which are completely different things. If you don’t know about these EMIs, it could get you in trouble.

In this article, I am going to explain all about the fixed vs floating interest rate, how the interest rate affects EMI, floating rate EMI changes, and the RBI repo rate EMI impact, which will certainly help you to understand how they work, and you might be able to avoid various troubles. 

Understanding Fixed vs Floating Interest Rates

Among the three important elements of loan repayments: Principal Amount, Tenure, and the Interest rate, which determines the cost of borrowing, the rate of interest can be the most difficult to understand, as it can vary depending on the policies of the lender. The interest rate could be fixed or floating.

• Fixed Interest Rate: 

It is the rate of interest that remains fixed once you borrow the item. Change in prices and the economy doesn’t have any impact on the fixed interest rate. For example, you purchase a car on 12% interest rate (fixed), but with an increasing market, the car price hikes; even in this situation, the lender would be bound to the same rate of interest and cannot amend the terms of interest. Use our car loan EMI calculator to simulate this scenario.

• Floating Interest Rate: 

If the rate of interest is not fixed and has room for changes, it is called a floating interest rate. It means that changes in the economic factors, inflation, or policy decisions from central banks can have a significant impact on the rate of interest, as well as your EMIs. Take a similar scenario as before, but this time you bought a car with a floating rate of interest, and the prices drop. Now, the lender is bound to lower the interest on your car according ot floating interest rate policies. It means you can save money by opting for a floating interest rate if prices drop or vice versa.

You should choose between fixed and floating interest rates, when it depends on the extent of risk you are ready to bear and the market conditions. Floating rates can help you to save money in case you believe that the rates will decrease; however, they are accompanied by the possibility of the rates increasing.

How Interest Rate Affects EMI

EMI is the money that you pay per month against your loan, including the principal and the interest. You can understand the impact of interest rates on EMI easily. An increase in interest rate means you will pay more interest in total, and this increases your EMI, assuming that the term of the loan remains constant. A lower rate, on the other hand, reduces the EMI and hence it is easier to pay back.

For example, consider a loan of ₹50 lakhs with an 8% interest rate for 20 years. Using a common EMI formula:

EMI = Pr(1+r)^n/(1+r)^n-1

• P is the principal 
• r is the monthly interest rate 
• n is the number of months 

The EMI might be roughly ₹41,822 at 8%. At 9% rate, EMI will increase to approximately ₹44,986, which is 3,000 higher every month. This demonstrates how small rate hikes can make it difficult. It also shows the need to consider potential changes when choosing your type of loan.

Floating Rate EMI Changes

The best thing about borrowing is that the EMI rates may change. The floating rates contrast with the fixed rates as they are bound to such benchmarks as the Marginal Cost of Funds-based Lending Rate (MCLR) or External Benchmark Lending Rate (EBLR), which may vary every three months or even less frequently.

In case of an increase in interest rates, the lenders tend to increase your EMI to cover the increased cost. They might also extend the loan period in order to maintain the same EMI (as per the regulation). Reduction of rates, on the other hand, implies reduced EMIs or reduced loan terms. The floating rates EMI adjustments would be good in downward trend rates but bad in upward rates. Borrowers must be keen on such changes as they impact cash flow and long-term savings.

• Advantages of Floating Rates: Typically, they start at a lower rate than the fixed rates; you might save money if the rates go down, and they track the economic rise and fall.
• Disadvantages: EMI changes may be difficult to predict as there are many risks in changing markets, and this may make budgeting more difficult.

RBI Repo Rate EMI Impact

The monetary policy instruments used by the Reserve Bank of India (RBI) have a lot in determining the setting of the interest rates, particularly the repo rate, which is the interest rate at which the banks borrow funds from the Reserve Bank of India. The RBI repo rate EMI is the one that influences the floating rate loans the most, because banks will transfer any alteration in the repo rate towards the consumers.

As an example, when the RBI increases its repo rate to combat inflation, the banks also increase their lending rates, and consequently, the EMIs to people with floating rate loans are also increased. Under the economic recovery after 2020, the repo rate increased by 4% to approximately 6.5%, which led to an increase in the EMIs of many house loan holders by 20% to 30%. Conversely, repo rates are reduced, such as those experienced during recessions and this cuts EMIs, which is desirable. Knowing the impact of the RBI repo rate on the EMIs will assist the borrowers in preparing in accordance with the changes and may shift to fixed rates in case of an increase in rates.

To compare the effects, we have a table of a hypothetical 15-year 30 lakh home loan in 30 lakh in India that looks like this:

Pros and Cons of Fixed vs Floating Interest Rates

When you choose between fixed and floating rates, you have to think about how stable they are and how much money you could save. Here’s a list:

Fixed Interest Rates:

• Pros:
  • You can easily plan your budget because the EMIs are always the same.
  • Protects against rising interest rates.
  • It is also best for the borrowers who don’t want to take risks.
• Cons:
  • Fixed rates are usually higher starting rates than floating rates.
  • Lowering prices will not save you any money.
  • There may be fees for paying early.

Floating Interest Rates:

• Pros:
  • Lower starting rates, which means lower EMIs at first.
  • If market rates go down, you can save money.
  • You have the option to swap or renegotiate.
• Cons:
  • You could have to deal with variations in floating rate EMI.
  • The RBI repo rate EMI impact could make things more expensive.
  • Needs to keep an eye on economic data all the time.

Friendly Asked Question

Conclusion

In order to handle your EMI, you should be aware of how to handle fixed and variable interest rates. To select the suitable loan that meets your financial requirements, compare EMIs using an online EMI calculator before finalizing your loan. Consider the degree of risk that you are ready to take and the market conditions, and see whether it is more worthwhile to concentrate on stability or searching the ways to save money. Never decide on loans without consulting lenders or other financial experts in order to ensure that your loans contribute to your financial well-being rather than being a liability.