The Hindu Business Line : Fixed or floating: Home loans get interesting

Fixed or floating? The debate has surfaced yet again for home-loan borrowers. As the yield on 10-year government paper inched up to a four-year high, it does look like the days of low interest rates are past. Home-loan interest rates have been moving up steadily from the second quarter of last year, much to the despair of floating rate borrowers. If the trend persists, a percentage point rise can be expected over the next year, if not at one go, spread over the next few quarters. The RBI Monetary Policy, to be announced on Tuesday, may provide clues on the interest rate scenario.

What do home-loan borrowers do now? Is conversion to a fixed rate loan beneficial? Will prepayment of your loan make sense?

Shift to fixed loans?

The difference between a fixed and a floating rate loan has increased from a mere half a percentage point in the previous year to about 1.5 percentage points now, making a shift at this point quite expensive. Which is why still about 85 per cent of the new loans is booked at floating rates. So, if your outstanding term is below ten years, you may be better off staying with a floating rate, as you will benefit from the lower floater for a few more months. As your tenure is short, the initial savings may work to your benefit.

A floater is a better option even if your tenure is beyond 10 years, say 20. Given that rates have been on an uptrend over the last 18 months, there may not be enough upside from hereon to justify a 1.5-percentage point premium and going in for a fixed rate. On the other hand, in the longer term, you may also benefit from a downturn in interest rates.

Those who have borrowed at floating rates and want to convert to fixed will now have to pay 1.75 per cent conversion charges on the principal outstanding amount (charges are for ICICI Bank and HDFC). Conversion charges for nationalised banks vary from one to two per cent depending on the bank. Some banks do not allow customers to convert at their convenience and it may thus be possible to do so only when the bank makes the offer.

Assume you have taken a loan of Rs 16 lakh at eight per cent for a 20-year tenure and have paid a principal of Rs 1 lakh. You plan to convert the balance to fixed rate of interest at 10.5 per cent. Now you have to pay a one-time charge of Rs 26,250. Your monthly commitment will increase by Rs 2,430.

To make up for the additional expense incurred and for the conversion to work to your benefit, your floating rate has to go up to 10.5 per cent. Therefore, conversion now seems an unwise decision .

If you stick to your floating rate loan, a half a percentage point increase in borrowing rates could increase your tenure by as many 25 months. As most institutions prefer to increase the tenure rather than the EMI, it will not affect your monthly outgo. If the interest goes down, the tenure will get re-adjusted automatically. Even if you are hunting for a fresh loan, floating rate is the better option.

Prepay your housing loan?

If you intend prepaying your loan, then it would make sense to go for a floating rate as most banks or financial institutions do not charge prepayment charges for floating rate loans. Fixed loans, however, carry prepayment charges of two per cent. This would make prepayment an expensive affair.

Normally, it's not advisable to make prepayment if you are enjoying tax benefits, at least for the first few years, whether you have borrowed at fixed or floating rates.

Assume you want to prepay Rs 1 lakh, you will not enjoy any tax benefit, other than from the reduction in the principal.

Assume you borrowed your home loan at nine per cent; your net effective cost of borrowing cost comes down to 6.3 per cent at the 30 per cent tax bracket. Instead of prepaying your home loan, if you invest the Rs 1 lakh in a five-year fixed deposit, you will get tax benefits under Section 80C and also earn interest of seven per cent per annum on the deposit. Your post-tax yield can be as high as 12 per cent if you are in the 30 per cent tax bracket.

Your additional earnings from the deposit will also compensate for the higher outgo on a further rise in your floating rate.

If both husband and wife are working and take a loan jointly, the effective borrowing rate will be even lower as each can get income-tax deduction up to Rs 1 lakh for the principal and Rs 1.5 lakh for the interest.

You are allowed to make part prepayment of your loan under certain conditions. The conditions are different for banks and NBFCs.

For instance, HDFC allows you to prepay only twice a year, provided your amount is at least three times the EMI. SBI is slightly more stringent. It does not allow you to prepay more than 50 per cent in the first five years.

Loan for insurance

A home-loan is a big liability and may account for close to 50 per cent of your savings. Given the huge risk, a loan cover term assurance is a must. You can opt for either a one-time or a regular premium.

The housing finance company itself could fund your lumpsum insurance premium. You can claim tax benefit under Section 80C for the premium up to a maximum of Rs 1 lakh.

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