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Are fixed-cum-floating rate loans right for you?

September 09, 2009 12:09 IST
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Fixed or floating rate loan? This is the most common question plaguing millions of borrowers. Which one is right for them? How will opting for one type of loan impact their finances?

These type of questions are commonly faced by the borrowers. So in order to help the borrowers, financial institutions have introduced fixed cum floating rate loans. Here is a lowdown on this type of hybrid loan.

Introduction to fixed cum floating rate loans: As the name implies, fixed cum floating loans are hybrid loans where the interest rate is fixed for the first few years. Then it becomes floating rate for the remaining part of loan tenure.

E.g. if you have taken a fixed cum floating loan with the interest of 7.5% for first 2 years, the interest rate for the first 2 years is 7.5%. After that, the floating rate prevalent at that time kicks in till the loan period is over.

Fixed-cum-floating rate loan vs floating rate loan: Let us compare how fixed cum floating rate loan compares with fixed rate loan. Assume Smita has taken a fixed cum floating rate loan of Rs 20 lakhs (Rs 2 million). It has an interest rate of 9% for the first year, after which it becomes a normal floating rate loan. The total duration of the loan is 15 years. Here is how Smita's calculation will work out.

Year 1: During this period, Smita pays the interest at the fixed interest of 9%. So the total amount she pays during the period is Rs. 174,903. Her monthly installment works out to be Rs 14,575.25. Let us say by the end of 1st year, Smita has paid off Rs 50,000 from the principal amount.

Now after the first year, the rate increases and she has 14 years left to pay off the balance amount of loan. As the rate has gone up, her EMI is adjusted accordingly to reflect the change and will be effective for the remaining portion of the loan.

Year 2: Let us assume the new floating rate is 11%. Now the EMI goes up to Rs. 22,797, which is much more than the current one.

On the other hand, had she opted for a floating rate loan right from the start, when the rate of interest was 10%, her monthly EMI would have worked out to Rs. 21,492. While the difference between both the EMIs may not seem to be significant, over a period of time, this difference will add up, thus saving Smita a substantial sum.

At the first glance, it may seem that Smita saves money by opting for the fixed rate of 9% for the first year, she will end up paying a significant amount from second year onwards.

Should you opt for it?

When choosing a loan, don't just look at the immediate interest rate you will be paying. Think long term. Read the terms and conditions of the loan carefully. Avoid the loans that have low interest rate in the initial years. Remember there is no free lunch. This is bait used by the lenders to entice gullible customers.

Find out if you can switch lenders, without any penalty. This is essential if your lender's new rate is higher than its competitors.

What is your bet on the interest rates? Do you think they will fall in future? If you think they will, then opt for fixed cum floating loan.

What about prepayment? Does the lender let you prepay whole or part of the loan without any penalty?

Take care of these factors that will let you enjoy the fixed cum floating loan without making it expensive for you.

Fixed cum floating rate loans are hybrid loans that are a combination of fixed and floating loans. You pay a low fixed interest rate in the initial years, after which it is converted into floating rate loan. But if at that time, the interest rate goes up, you will end up paying higher EMI as the new EMI reflects the increase in rate.

However you stand to benefit if the rate goes down, since you will end up saving money. So weigh the pros and cons before deciding.

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