When we buy a house, we make a substantial financial choice that will affect us for the rest of our lives. It’s an excellent investment, but you need to consider several factors, including the location of your new house, the down payment you can afford, the size of the primary loan, and the length of the loan term.

The interest rate is one of the most critical aspects of this loan. Lenders may select between a fixed interest rate and a variable interest rate on their home loan with banks, non-banking finance firms, and housing finance organisations. Floating interest rates are the subject of today’s article, which will educate you on the subject.

A “floating interest rate” is one whose interest rate changes during a loan or other financial commitment. In contrast to the fixed interest rate system, this is a variable interest rate system. For the duration of the fixed rate, the interest rates are the same. Depending on market circumstances, loan interest rates are either fixed or variable. An in-depth discussion of the benefits and drawbacks of floating interest rates and what is floating interest rate is provided in this blog.

Floating Interest Rate

What is floating interest? The floating rate of interest, meaning the market or an index, determines how much the interest rate will change. Throughout the repayment period, the interest rate is subject to fluctuation (increases and decreases).

The Reserve Bank of India (repo rate) determines the base rate of the floating interest rate calculation. The base rate fluctuates in response to the state of the market. Interest rates are also linked to the Federal Reserve’s key interest rate. The lender adds the spread (extra interest) to the repo rate to determine the interest rate. Interest rate changes are passed on to the borrower, and the loan balance is adjusted to reflect the new interest rate.

Also Read: Investing in Mutual Funds involves risk

Floating interest rates might often fluctuate depending on your loan’s terms and circumstances. They might be changed every three months, six months, or a year.

The EMI amount will not be affected by changes in interest rates throughout the loan term. Loans with floating interest rates have variable terms but are exempt from prepayment penalties.

The floating interest rate is also less expensive for financial institutions to provide than the standard, long-term fixed interest rate. As a result, variable prices might help you save money.

Advantages and Disadvantages of Floating Interest Rate

Advantages

The following advantages are associated with interest rates that are free to move:

• Rates are tied to the repo rate: When borrowing money from the Reserve Bank of India, the repo rate is used (RBI). Variable interest rates on loans are closely linked to the repo rate. Long-term loans are more cost-effective than fixed interest rates. Lending institutions also increase the repo rate by a margin known as “spread.” Over and above the repo rate, a spread is charged.
• Cheaper: The short-term volatility of floating rates is due to their reliance on the market. In contrast, variable interest rates are lower than fixed-rate loans. An interest rate increase may be as much as the market sees fit under a variable rate system. Even if interest rates climb by 1-2 percent, you’ll still save more money. When interest rates rise, floating interest rates are adjusted. Loan repayments aren’t going to grow, but the loan’s term is longer.
• Also, as repo rates fall, floating rates are modified to shorten the loan term rather than increase the monthly payment.
• No penalty for early payment: The lender cannot impose fines on loan prepayments under RBI standards.

Disadvantages

A variable rate has several drawbacks, including:

• Inconvenient and Unpredictable: Floating rates make it harder to plan and prepare for the future since they fluctuate. In addition, it is tough to keep up with the EMI payments due to the fluctuating interest rates. The lack of clarity and stability in EMIs results from variable rates.
• Financial planning is challenging since interest rates fluctuate so often. Due to unfavorable market circumstances, premiums may rise and become more expensive.

Who Should Opt for a Floating Interest Rate?

Only those who can afford a floating interest rate should be used.

If you believe the base rate will stay the same or decrease over time, you should choose a variable interest rate loan. Under these conditions, you will either have the same interest rate for the length of the loan or pay less interest.

For example, if the Reserve Bank of India lowers the interest rate, you may take advantage of the reduced rates until they are dropped again. Fixed-rate loans are less desirable than floating-rate loans because falling rates make them more attractive.

Additionally, if you choose a variable rate, you can make prepayments using the money you have on hand. Examples include a pay rise or a bonus, a year-end bonus, a sales incentive, or any combination. Your overall interest expense is reduced since you can repay the loan sooner. A variable interest rate is an excellent choice for those who expect to earn more. You’ll be able to pay back your debt faster if you make more money. As a result, you’ll gain from floating interest rates if you’re ready to accept the risk of fluctuating interest rates in exchange for a faster loan payoff.

Conclusion

Economic factors such as interest rates have a significant impact on the economy. When deciding whether or not to purchase a property, borrow money, or put money in savings, they aid people and businesses daily. Borrowing is directly related to interest rates, which, in turn, influences economic growth. A rise in interest rates directly impacts the price of stocks, bonds, and derivatives. To become a world-class financial analyst, you must take FMVA (Financial Modeling and Valuation Analyst). Nuuu is the official supplier of this course.