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Play safe with a fixed-rate home loan if your DTI is high

Floating rate loans are the cheapest. The short-tenure fixed loans would normally be about 0.25% to 2% costlier than floating rate loans, while the long-tenure fixed loans are the most expensive…at around 2-4% more than the comparable floating rate loans.


In terms of interest rate applicability, you will come across broadly three types of home loans, namely:


1. Floating interest rate home loan: This is the most commonly available option wherein the interest rate is linked to the bank`s Base Rate. As and when the base rate changes (which may happen as often as every quarter), the interest applicable on your home loan will also change accordingly.


2. Short-tenure fixed rate home loan: In order to attract customers, banks offer the so-called `teaser` loans wherein a low fixed rate is applicable for an initial period - normally for 2 to 5 years - and thereafter it may (a) either be converted into a normal floating rate loan or (b) the interest may be reset for another 2-5 years.


3. Long-tenure fixed rate home loan: In such loans the interest rate is `generally` fixed for either the entire loan tenure or at least for 7-10 years. (Beware! Banks are known to add a fine print that in case the conditions become too adverse, they retain the right to increase the rate. Ideally, such a clause should not be accepted.)


The specifics of the scheme would, however, differ from bank to bank.


Among the three, floating rate loans are the cheapest. The short-tenure fixed loans would normally be about 0.25% to 2% costlier than floating rate loans, while the long-tenure fixed loans are the most expensive…at around 2-4% more than the comparable floating rate loans.


This is but natural. As long as you bear the risk of interest rate movements, the rates will be low. However, if the bank has to bear that risk it will charge a higher rate.


The lower interest on the floating rate loans makes them the first choice for any borrower; especially given the fact that the loan amount runs into many lakhs. As such, lower rate would translate into lower EMIs.


Moreover, under the present economic scenario, the interest rates are likely to go down in the near future. Hence, getting tied to a fixed rate today may not be a good idea.


Also, RBI has been taking steps from time to time to address the concerns of the borrowers regarding banks not readily passing on the benefit of rate reduction to them. (It has been observed that banks tend to promptly raise the interest rates. However, they are often reluctant to reduce them for the existing borrowers while at the same time wooing new customers with lower rates.)


Nevertheless, many people are risk averse and hence not comfortable with the uncertainty in interest rates, especially when the loan runs over 1-2 decades. This is a very pertinent apprehension. If you do not like risk, you could opt for long-tenure fixed rate loans even though they are somewhat expensive. It is like paying insurance premium for protection against rise in interest rates.


But risk is rather a qualitative aspect. And sometimes people have exaggerated fear of risk. So how does one `rationally` determine his or her risk appetite and make the right choice?


Financial prudence suggests that your total EMI outgo - for all loans put together including the proposed home loan - should not be more than 45-50% of your total monthly take-home pay. This, in financial parlance, is referred to as Debt-to-Income (or DTI) ratio.


Therefore, if your DTI at current interest rates is already around this mark, any hike in the interest rates in future is likely to push you into the danger zone. Hence, it would be safer to opt for fixed rate loan.


Only when your DTI is less than 30-35% and you have the cushion and the capacity to absorb the risk of higher interest rates, should you consider a floating-rate loan.


By the way, making a choice between fixed and floating rate is never a one-time decision that would hold good for next 10-20 years. Many changes will happen in the interim. As such, you must be prepared to make at least 2-3 switches during the loan’s lifetime.


If you have a fixed rate loan, you can always prepay and switch to a cheaper or a floating rate loan if in future the interest rates fall or your DTI comes down. Or if you had earlier opted for a floating rate loan, you can always switch to fixed-rate later if the interest rates start becoming too expensive. You would, of course, have to consider the costs involved in switching.


It may, however, be noted that while almost all banks are willing to lend at floating interest rates, fixed interest home loans are offered by only a few of them. Therefore, you will have to hunt a bit harder to get a suitable fixed rate loan.

Sanjay Matai is a personal finance advisor, author and online financial trainer. There`s a lot more free stuff to read on his blog (thewealtharchitects.blogspot.in).

First Published on Jun 12, 2013 02:36 pm
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