Ever wondered how a floating rate loan works? Ever thought about why your interest rate is going up even 3 years after you borrowed to finance your dream home? I’ll try to explain how floating rate loans work and who they benefit. I cannot tell you whether you should choose fixed rate or floating rate. But, I can give you information which will help you arrive at a logical decision.
This post was inspired by a customer of mine who asked me, ‘Why am I paying more and more interest for money that the bank borrowed (from other sources) and lent to me more than 3 years ago?’
Fact # 1 A floating rate loan is a product designed to make money for the bank.
Never ever think that a financial product is designed to benefit the customer. The bank is a business, not a charity, and they aim to make a profit from lending to you.
Fact # 2 A floating rate loan is designed to pass on interest rate risk to the customer.
That means, the bank doesn’t want to pay more interest for the money its borrowing than the interest income it is going to earn from lending to you. So the bank makes sure that if funds become costlier, their profit margin is protected. This is the primary idea behind floating rate loans.When borrowing costs go up for the bank, it will hike your floating rate to maintain its profit margin.
Fact # 3 The floating rate loan is not cheaper than a fixed rate loan
Yes, the floating rate is always 150-200 basis points (thats 1.5-2% for the uninitiated) lower than the fixed rate. This is an artificial difference created by the bank to make floating rate loans more attractive to customers. The fact is, you’ll never know whether a floating rate loan is cheaper or costlier than a fixed rate loan until you’ve finished repaying the loan. the other barrier created by banks to prevent you from taking a fixed rate loan are the charges levied on prepayment and pre-closure. There are never any prepayment charges on floating rate loans.
Fact # 4 When you choose a floating rate loan, you are essentially making a bet.
When you choose a floating rate loan, you are betting that interest rates will either stay in the current range or drop further. But you don’t know the factors that contribute to the rise and fall of rates. So, you are actually placing a bet.
Fact # 5 The RBI decides floating rates
When the central bank raises or reduces rates, it does so as an indicator. A rate hike by the RBI doesn’t necessarily mean your bank has to hike its lending rates. A bank’s lending rates are decided by its own cost of funds. This means that a bank that has a better treasury department can actually lend at cheaper rates. And this does happen. For example, our nationalized banks lend at lesser rates because they have access to a huge deposit base (SBI has more customers than the population of Australia).
Any doubts about home loans? Feel free to ask!