Latest RBI Guidelines: Borrowers Can Now Switch Between Floating & Fixed Interest Rates

Before we delve into the current guidelines provided by the RBI and which of the interest regime is best for home loan borrowers considering the current home loan interest rate conditions, let's first see the difference between the floating interest rate and fixed interest rate.

What Is a Fixed Interest Rate Home Loan?

In a fixed rate home loan, the interest rate is set at the time of acquiring the loan. Beyond the typical fixed interest rate option where the interest rate remains constant throughout the loan's entire duration, some variations enable you to lock in your interest rate for specific periods, such as 2, 3, or 10 years, and can be reset by the lender if needed.

Choosing a fixed rate home loan offers a sense of certainty, as you are aware of your repayments right from the loan's initiation. This helps in accurate planning and budgeting of your finances. Consequently, there is a reasonable level of predictability for the loan duration, monthly EMI obligations, and overall interest expenditure.

Generally, fixed rate loans are typically set 1% to 3% more compared to floating interest rate loans. If the difference is substantial, you might lean towards a floating interest rate loan. However, if the gap is negligible or minimal, it's advisable to evaluate your circumstances and requirements before deciding between a fixed rate loan and a floating rate loan.

When Should You Opt for a Fixed Interest Rate Home Loan?

It makes sense to opt for a fixed rate home loan in the following situations:

• You are content with the monthly EMI amount you are committing to pay. This amount should stay within the range of 25-30% of your net monthly income.

• You anticipate a situation where interest rates might increase in the future and therefore, prefer to secure your home loan at the current rate.

• In case the interest rates have recently decreased, and you find the current interest rate acceptable, it's wise to lock it in with a fixed interest rate loan. For instance, if a home loan interest rate was 9% a few years ago and has now dropped to around 7.50%, and you are both mentally and financially comfortable with this rate, you can opt for a fixed rate loan.

What Is a Fixed Interest Rate Home Loan?

Commonly known as the 'variable interest rate home loan,' these loans are linked to the lender's benchmark rate, which in turn aligns with the prevailing market interest rate. If there is a change in the benchmark rate, the interest rate on the loan adjusts proportionately.

The interest rate for these loans is updated at specific intervals. These intervals can be time-based, such as every quarter or half of a financial year, or they might be personalised for each customer based on their home loan's initial disbursement date. Alternatively, the update might be tied to your loan's anniversary.

Financial institutions typically retain the authority to modify the interest rate adjustment schedule. If market rates change during the assessment period, your rates will also be adjusted accordingly-either upward or downward. If the rate rises, your remaining loan tenure will be extended, and vice versa.

This strategy helps prevent frequent alterations to your EMI, which could affect your cash flow. However, if you prefer, you can ask the lender to modify your EMI instead of adjusting the loan tenure.

When Should You Opt for a Floating Interest Rate Home Loan?

It makes sense to opt for a floating rate home loan in the following situations:

• If you anticipate a general decline in interest rates over time, opting for a floating interest rate loan in this situation would lead to a corresponding decrease in the interest rate on your loan, ultimately lowering your loan's overall cost.

• Floating rate loans are suitable for individuals who have uncertainty about the direction of interest rate fluctuations and would prefer to align their rates with the prevailing market conditions.

• Floating interest rate loans are usually set at a slightly lower interest rate compared to fixed rate loans. Hence, if you want to save on your total interest outgo in the short term, a floating interest rate regime can provide you with a cost advantage for your loan.

Now, Let's Go Back to the RBI Guidelines We Were Discussing;

The RBI, on Friday, announced that banks allow borrowers the choice to change their floating interest rates to fixed rates.

"Regulated entities shall ensure that the instructions are extended to the existing as well as new loans suitably by December 31, 2023. All existing borrowers shall be sent a communication, through appropriate channels, intimating the options available to them," said RBI in a statement.

The circular further stated, "In terms of extant instructions of Reserve Bank of India, regulated entities (REs) have the freedom to offer all categories of advances, either on fixed or on floating interest rates basis."

The central bank also stated that it had received numerous customer complaints regarding the elongation of loan duration or the increase in EMI amounts for loans with floating interest rates. As a result, lenders are now obligated to consider the borrower's loan repayment capacity when approving these loans.

As part of the new regulations, the central bank outlined that the banks and non-banking financial institutions are required to specify the permissible frequency at which a borrower can switch during the loan period. Lenders must transparently convey the potential impact of changes in the benchmark interest rate on both the loan and the EMI.

Borrowers will also have the option to choose between increasing their EMI amount, extending the loan duration, or a combination of both choices. They can also make partial or full prepayments at any point during the loan period.

According to the RBI, any relevant fees for transitioning loans from floating to fixed rates and any other service or administrative costs associated with using these options will be clearly disclosed in the loan approval letter. The same transparency will apply when these charges are revised over time by the regulated entities.

Regulated entities (REs) will ensure that extending the loan tenure for floating interest rate loans won't lead to negative amortisation.

The RBI stated that these guidelines must be applied to both existing and new loans by December 31, 2023. All current borrowers will receive communication through appropriate channels informing them about the available options.

So, Which Retail Loan Interest Regime Should the Home Loan Borrowers Choose Considering the Current Home Loan Interest Rate Trend?

Navigating the realm of home loans can prove to be intricate, particularly given the array of variable options at play. As elucidated, both the fixed and floating interest rate home loan alternatives come with distinct pros and cons. However, in the process of making your decision, it's crucial to evaluate your ability to make repayments and opt for the choice that won't adversely affect the overall cost of your home loan. It is also advisable to compare diverse lenders and their proposed interest rates.

Since most financial experts are expecting a drop in the home loan interest rates before the end of 2023, it makes sense to opt for a floating home loan rate when taking a home loan.

Having said that, the future trajectory of home loan interest rates is often challenging to forecast. It is plausible that housing loan interest rates might shift counter to your expectations, leaving you with an unfavourable interest rate option. Nonetheless, there's no need to excessively fret about potentially making an incorrect decision about your housing loan. Remember, you retain the flexibility to switch between a fixed rate and a floating rate housing loan whenever you wish, though lenders typically impose a nominal fee for this provision.

If you remain uncertain about the appropriate type of housing loan for your situation, you can consider selecting a hybrid loan that combines both fixed and floating rates. This approach is particularly beneficial if you are currently managing other loan repayments and have structured your cash flows to cover your loan commitments for the initial 3-5 years. During this timeframe, you can opt for a fixed rate. Subsequently, beyond this initial period, you can transition to the floating rate option for the remaining tenure of the housing loan.

Is This a Good Move by the RBI?

This move would certainly enhance transparency and provide borrowers with a better understanding of their commitments. However, the process of choosing and switching the interest regime and closing loans is quite complex and involves related expenses. Therefore, while having the theoretical option to switch exists, in practice, switching the interest regime and achieving the goal of interest saving might be quite challenging for a common borrower.

Should You Opt for a Higher EMI or Elongation of the Loan Tenure?

Whether you should opt for a higher EMI or elongation depends on your monthly cash flow and your remaining loan amount and tenure. If the outstanding amount and remaining tenure are relatively short, you might be comfortable with a larger EMI to ensure timely loan repayment. On the other hand, if you face challenges with your monthly income, it is advisable to choose a longer loan tenure.

To conclude:

It is not feasible to definitively state that one type of loan surpasses the other; opting for either the fixed or floating home loan interest rate depends on your requirements, inclinations, and financial profile. The factors discussed above should guide your selection of the option that aligns best with your circumstances. Despite the fact that your chosen loan type influences the ultimate cost of your home, the good news is, you have an option to switch the interest regime considering prevailing circumstances.

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KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.

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