Shikha should know that predicting future interest rates is harder than deciding how much EMI she can comfortably pay. A fixed rate home loan in which the interest rate is pre-determined for the tenure of the loan, provides a known cash outflow for a known period. The risk to Shikha is that it could be a higher rate which she puts off for a longer period in the future.

In a floating rate home loan, the interest rate changes on a quarterly basis as per the market interest rates during the tenure of the loan. It will be affected by the change in the base rate of interest as indicated by Bank, which in turn is linked to market rates of interest and economic factors. Lenders usually adjust the tenure of the loan and keep the EMI constant in floating rate loans. If interest rates fall in the future, Shikha will benefit from the reduction in her repayment period. If rates rise instead, his repayment period may increase.

In both the cases, Shikha should look at the EMIs first, and ensure that she is able to pay comfortably and is left with enough surplus for other needs. The main difference is that in a fixed rate loan, the bank takes on the risk of future rates going up, whereas in a floating rate loan, the crest takes on the risk that future rates may rise. Barring a fortunate situation where Shikha is able to lock in a very low fixed rate, a floating rate loan is a better option as it does not try to predict future rates.

Shikha should be aware that her bank may have a better view of interest rates than herself. Could be a good clue in pricing. Fixed rate loans may cost more than floating rate loans if the bank feels that rates will rise. It helps the banks to earn more in the form of increase in the rates through the floating rate option. If the fixed rate price is lower than the floating rate, the bank is anticipating a fall in interest rates. This helps the bank to lock in a higher fixed rate. It is important to know whether the fixed rate home loan is fixed throughout the tenure of the loan, as most lenders offer a loan that is fixed for an initial 2-5 years and then becomes floating.

(Content on this page is courtesy of Center for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Aarti Bhargava and Labh Mehta.)