One of the premier area of business for many banks and financial institutions is Home loan segment. The increasing competition in banking sector (especially after the emergence of the private sector lenders like ICICI bank, HDFC bank etc;) for capturing the home loan market share has benefitted the customers the most. Banks and other lenders like HDFC, DHFL have made the customer satisfaction their primary motive to expand their home loan portfolio.
Of all the factors that tilt a customer in favor of a particular lender, the interest rate offered is the most important. It is relevant to note that RBI doesn't fix the interest rates for the loan offered by every lender. Every lender is allowed to fix a rate of interest and design a financial product subject to the regulations prescribed by the RBI. There are predominantly three types of interest rates offered to home loan customers.
1. Loans with a fixed rate of interest:
In this type, the rate of interest as specified when the loan agreement is signed will be effective for the whole loan tenor irrespective the rates prevailing in the markets in the future. In other words, the home buyers will not be affected by any change in interest rates in the future.
Since the rate of interest is fixed, a buyer can calculate the EMI(Equated Monthly Installments – cash outgo that the buyer would need to pay for the loan; includes both principal amount and the interest on outstanding loan) well in advance. This helps the buyer to forecast his cash outflow in the loan tenor and plan his financial needs accordingly. Naturally, it will be beneficial if a buyer knows in 2011 that he needs to pay Rs.19650/month as EMI for a 15 year tenor home loan right in the beginning.
2. Loans with a floating rate of interest:
In this type, the lender offers the loan at a floating rate (rate which is subject to change in response to prevailing market conditions). This means that the rate of interest will not be fixed and consequently a buyer cannot estimate his EMI payments for the entire loan tenor accurately in the beginning. Floating rate has a variable rate of interest that is subject to change because of the changes in interest rates in the market. This may appear as a severe disadvantage over the fixed rate loans because the EMI under this type is not fixed, but it is not necessarily be so.
Experts advise home loan buyers to choose floating rate of interest as the interest rates will continue to fall in the long term.
Let say that a loan tenor is 15 – 20 years and the fixed rate is 12% and floating rate is 11%. If due to a change in market conditions the market rates fall to 9%, only those who chose floating rate would be benefited as the EMI will fall with a fall in interest rate. A buyer who chose fixed rate cannot enjoy the benefit of a falling interest rate. Of course, those who opted for fixed rate will benefit in the time of rising interest rate scenario(like the one we are witnessing for the past two years).
Still, experts believe that the interest rate will continue to change and fall in the long term, and therefore suggest buyer to opt for a floating rate home loan.
3. Loan with a fixed rate for a period and then variable rate:
Widely known as Teaser loans, these loans try to offer both the benefits of fixed and floating interest rates. In this type, loans are offered at the fixed rate of interest for the first 2-3 years and then at the floating rate of interest for the remaining tenor of the loan. This was extensively used by SBI during the global recession in the year 2008-2009 and helped SBI claim the market leader status.
Almost all home loans fall under the above three categories while the remaining home loans are offered as a package structured to the needs of the buyer. Since we are just analyzing the basic of home loans, we have focused only on the widely used.
The author, Srinivas K is a Cost Accountant, is currently coaching CA/CWA/ACS in Chennai. The author is also a tax consultant. email: firstname.lastname@example.org.