Home Loans & Mortgage Loans Better Understood (Part-2)

In our last post we discussed different terminologies and definitions that are used in Home Loans / Mortgage loans. In this post we shall discuss in details the different type of interest rates available with various financiers while they provide Home loans. Primarily there are two types of interest rates, one is the “floating rate” and the other is the “fixed rate”Floating Interest Rate

Floating interest rate, also known as “Variable Interest Rate” or “Adjustable Interest Rate” refers to any type of interest rate that is not fixed and keeps varying over its tenure typically using a base rate. In India the base rate is fixed by RBI and the general nomenclature for this is Prime Lending Rate or simply PLR. The actual floating rate of interest paid by borrowers is generally a margin rate added on to the PLR. Very rarely we come across situations where the floating rate is lesser than the base rate.

It is to be noted that Home loans / Mortgage loans in most countries are floating rate loans. In India very unfortunately borrowers predominantly do not understand the concept of floating rate and often mistake that the tenure of the loan is sacrosanct and that it does not change. This can be attributed to the fact that very few borrowers essentially understand the terms and conditions before they sigh the mortgage documents.

Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield curve. In return for paying a lower loan rate, the borrower takes the interest rate risk: the risk that rates will go up in future. In cases where the yield curve is inverted yield curve, the cost of borrowing at floating rates may actually be higher; in most cases, however, lenders require higher rates for longer-term fixed-rate loans, because they are bearing the interest rate risk.

Fixed Interest Rate

Fixed interest loans are interest rates that typically do not fluctuate at all over their tenure. The borrower in this case can know for sure what is their future payments as it is largely not changed. Generally fixed rates are higher than the floating rates and people generally do not prefer either due to ignorance about floating rate or due to the fact the floating rates are typically lower and can offer lesser EMI in the immediate time frame.

A fixed interest rate is based on the lender’s assumptions about the average discount rate over the fixed rate period. For example, when the discount rate is historically low, fixed rates are normally higher than variable rates because interest rates are more likely to rise during the fixed rate period. Conversely, when interest rates are historically high, lenders normally offer a discount to borrowers to fix their interest rate over time, as rates are more likely to fallduring the fixed rate period.

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