Significance of Floating Rate-based Home Loans

Last Updated : June 1, 2020, 6:30 p.m.

Having your own home at some point in life is a top priority for all the people living in India. But not everyone can arrange funds to buy their dream house. Soaring prices come in their way and all they need is a little financial help so that they can purchase their homes. For this purpose, individuals have the option to opt for a home loan granted by several banks and non-banking financial companies (NBFCs). With the help of home loans, an individual can take the required loan amount at affordable interest rates and repay it within a flexible tenure.

But there is an important thing that an individual has to choose while finalizing the home loan option — which kind of interest rate to choose between fixed and floating? The loan repayment is done by the Equated Monthly Installments (EMI) and your choice between fixed and floating rate of interest will directly impact your EMI amount. So, it is important to know about the floating rate of interest in the home loan so that you can choose wisely at the time of loan application. In this article, we will tell every aspect of the Floating Rate in the Home Loan — what exactly is this kind of rate, what are the types of it, when you should opt for it, what is the impact of choosing this rate, its advantages, etc. So, let’s begin!

What is the Floating Rate of Interest?

Interest rate is one of the most important aspects that you must look at while applying for a Home Loan facility. Home loans are generally taken for a long tenure ranging from 20 to 30 years and the loan amount is also usually higher ranging from INR 30 lakh to beyond INR 1 Cr

If you do not keep the interest rate in check, you can end up paying a huge interest amount during your overall tenure. Home Loan interest rates are mainly of two types — Fixed Rate and Floating Rate. The interest rates remain fixed if you opt for a fixed rate of interest and so you will have to pay a fixed EMI amount. However, in the case of a floating rate of interest, as the name suggests, the interest rates tend to vary according to market fluctuations. A floating rate is also known as the Adjustable Rate Home Loan.

One of the significant benefits of choosing a floating rate of interest in a home loan is that it is a lot cheaper than home loans at fixed interest rates. Floating rate home loans are disbursed at 3% to 4% lower than that of a fixed rate. So, the interest outgo will be different in both cases. Due to the dependency on the market conditions, an individual may have different floating interest rates at different points in their tenure. The main reason behind the popularity of the floating rate of home loans is the flexibility it provides to home loan borrowers.

You can understand the difference in interest outgo regarding both fixed rate and floating rate home loans. Following is an example of a home loan of INR 40 lakh taken at 8.50% and 11.50% per annum at floating and fixed interest rates, respectively, for 18 years. Check the below table!

So, you can see the interest liability increases INR 16,66,119 when you choose a fixed-rate home loan interest rate over the floating rate of interest. By choosing the floating rate in the home loan, you can save this amount during your overall tenure. This is one of the huge benefits of the Floating rate in the home loan.

What are the Different Benchmarks of Floating Rate in the Home Loan?

When we talk about Floating rates, these are linked to the lender’s benchmark rate, which can be internal or external. There are a total of three benchmarks with which floating rates are generally linked with. These are Base Rate, MCLR, and RLLR. We are providing details about all of these benchmarks so that you can choose accordingly.

Base Rate Benchmarking

This is one of the first benchmarks that was in use until April 2016 for all kinds of loans. With the base rate benchmarking, banks can fix their home loan interest rate with reference to the base rate. Home Loan interest rates linked with Base rate benchmarking tend to change if there is any change in the base rate. For example, if the Reserve Bank of India (RBI) decides to cut its repo rate, your home loan interest rates will also be decreased but may change from one lender to another.

If you are someone who has taken a home loan before April 2016 and want to shift to different benchmarking other than the base rate, you can do so by paying nominal fees for this facility. These fees may change from one lender to another.

MCLR Benchmarking

This is the second kind of benchmarking followed by different lenders. RBI introduced this benchmark in April 2016. Before this, home loan rates were used to link with the base rate which we told earlier. The best thing about MCLR-linked lending rates is it takes the current cost of the funds as opposed to the average cost in base rate linked lending rates. You also need to remember that the MCLR-linked rate is an internal benchmarking method and in case of the lending rates linked to MCLR, banks also charge a spread, mark-up, or margin with the lending rate. Your final interest rate will be MCLR + spread charges. Thes mark-up charges may differ from one lender to another.

The problem with the MCLR benchmarking was its reset period clause because of which borrowers were not able to get the full benefits in any kind of rate cut (an increase or decrease) in the repo rate. The reset period is generally six months or 1 year for most of the banks. So, for example, if someone opts for the home loan in January 2018, he or she will not get any change in a rate before July 2018 or January 2019 depending on the rest period clause of a particular lender. Plus, the transmission of repo rate cuts was not transparent even in the case of MCLR-based home loans. That’s why there was a need to implement a new lending rate calculation method.

RLLR Benchmarking

After seeing that borrowers are not getting the benefits of the rate cuts, RBI mandates commercial banks to link their lending rates with the Repo Rate, which is the rate at which lenders borrow money from the RBI. Repo Rate is one of the external benchmarks fixed by the RBI and changes every 2 months. Lending rates linked to this rate are known as the Repo-linked Lending Rate (RLLR). After its introduction on October 1, 2019, all banks provide home loans based on the RLLR. There has been a lot more transparency in the interest rates due to the external benchmarking.

In this particular benchmarking, the transmission rate is quite quick and borrowers can enjoy the benefits instantly. From October 2019 to May 2020, the RBI has cut the repo rate by 140 basis points. In response, banks have also cut their RLLR by the same proportion. The final rate of interest may depend on your overall profile and credit score.

All the borrowers who have opted for a home loan on or after October 1, 2019, their home loan interest rates will be linked to repo-rate benchmarking. If you want to shift your home loan from MCLR or Base rate benchmarking, you can do it by paying nominal fees. You can have a look at some of the major points that help in differentiating MCLR and RLLR-linked lending rates. These points will give you a clear view of both benchmarking methods.

What are the Benefits of Floating Rate in the Home Loan?

Now you have enough information about the floating rate in the home loan, you must know about the benefits that you can enjoy if you choose a floating rate over a fixed rate in the home loan. We are providing you some of the benefits below which you can look at.

• Suppose you want to pay your outstanding loan amount before your fixed tenure. You don’t need to pay any kind of prepayment charges on a floating rate home loan. However, in the case of a fixed rate loan, you will need to pay prepayment charges as applicable.
• The floating rate in the home loan changes according to the market fluctuations, so if a floating interest rate climbs higher than the fixed rate in the future, it will also come down at some point in time, and the situation will even out in the end as the tenure of home loan is generally long. You just need to have patience in such times.
• If you are expecting interest rates to fall in the near future, you can opt for a Floating Rate in the home loan as you can save a lot of money while repaying the home loan due to low-interest rates. Low-interest rates will directly impact your EMI amount.
• You can switch from Fixed to Floating or Floating to Fixed at any point in your tenure by paying nominal fees.