Floating Interest Rates

If you plan to take out a loan, one of the most important considerations is the type of interest rate you should opt for. Generally, you have two options: fixed interest rates and floating interest rates. While both types have their pros and cons, you must choose what suits your financial goals in the long term. To help you make a sound financial decision, we have covered floating interest rates in detail in our blog. Read on!

Table of Content

• What is a Floating Interest Rate?
• Example - Floating Interest Rates
• Factors Influencing Floating Interest Rates
• Pros and Cons of Floating Interest Rates

What is a Floating Interest Rate?

A floating interest rate, or variable interest rate, is a financial mechanism where the interest rate on a loan or debt obligation fluctuates in response to changes in the broader financial market. Unlike fixed interest rates, which remain constant for the entire loan duration, floating interest rates are dynamic and can rise or fall over time. This change in interest rates is usually connected to an outside benchmark, like a vital lending rate set by central banks.

Example - Floating Interest Rates

Let's consider a real-life example of Floating Interest Rates in the Indian context for a homebuyer who has invested in an apartment in Noida and has taken a home loan from ICICI Bank with a floating interest rate of 7.35%.

In this scenario, the homebuyer secures a home loan from ICICI Bank at an initial interest rate of 7.35% per annum. This rate is referred to as the "floating" interest rate because it is subject to change based on market conditions, specifically linked to a benchmark rate like the Reserve Bank of India's (RBI) repo rate or the Marginal Cost of Funds Based Lending Rate (MCLR).

Here's how it works:

1. Initial Rate: When taking the loan, the homebuyer's interest rate is fixed at 7.35%. This rate will determine the monthly EMI (Equated Monthly Installment) payments for the loan.
2. Rate Adjustments: The floating interest rate is not fixed for the entire loan tenure. It can change periodically based on the fluctuations in the benchmark rate. Banks review and adjust their lending rates periodically, such as quarterly or annually.
3. Market Changes: The RBI reduces the repo rate during one of its policy reviews. Since the homebuyer's loan interest rate is linked to the repo rate, their floating interest rate can also decrease due to this change.
4. Impact on EMI: If the interest rate decreases, the homebuyer will benefit from lower EMIs. They will pay less towards interest and more towards the principal loan amount. This can result in cost savings and an earlier loan repayment.

Conversely, if the benchmark rate increases, the homebuyer's floating interest rate will also rise, leading to higher EMIs and increased interest payments.

Factors Influencing Floating Interest Rates

Floating interest rates are influenced by a multitude of factors, as discussed below -

Economic Indicators

• A strong economy with high GDP growth, low unemployment, and positive consumer confidence can increase interest rates.
• Conversely, a weak economy with slow growth, high unemployment, and low confidence can decrease rates.

Central Bank Policy

• In India, the Reserve Bank of India (RBI) sets the benchmark repo rate, influencing all other loan rates.
• When the RBI raises the repo rate, floating interest rates typically follow suit, becoming more expensive.
• Rate cuts by the RBI can make loans cheaper, boosting borrowing and economic activity.

Inflation

• High inflation, which erodes your money's value, compels lenders to charge higher interest to protect their returns.
• Low inflation allows for lower interest rates, encouraging borrowing and investment.

Credit Demand

• Due to increased demand, banks can charge higher interest rates when many people or businesses need loans.
• Conversely, with low demand, banks may offer lower rates to attract borrowers.

Government Bond Yields

• Yields on government bonds or “Government Securities" or "G-Secs” like Treasury Bills (T-Bills), Sovereign Gold Bonds (SGBs), State Development Loans (SDLs), etc., act as a reference point for floating rates.
• Rising bond yields may lead to higher floating rates, making them more competitive investments.

Global Factors

• International economic turmoil or events like financial crises can lead to lower interest rates in India as investors seek safer assets.
• Global economic trends also play a role, with strong global growth potentially pushing rates.

Market Sentiment

• Optimistic investor sentiment about the future economy can nudge interest rates higher.
• Uncertainty or pessimism about the future can cause rates to fall.

Borrower Risk

• Borrowers with a weaker credit history may face higher interest rates due to the increased risk of default.

Liquidity

• When there is less money in the financial system, banks may raise interest rates to incentivise lending.
• Ample liquidity can lead to lower rates as banks compete for borrowers.

Regulations

• Government policies and regulations regarding lending and finance can impact interest rates.
• Regulation changes can affect lenders' costs and, consequently, the rates they offer.

Floating Interest Rates: Pros and Cons

Floating rate locks offer a unique borrowing option with advantages and disadvantages. Understanding these nuances is crucial before committing to a floating rate loan.

Pros

• Lower Initial Costs: Floating rate loans often require smaller down payments than fixed-rate loans, making it attractive for borrowers with limited upfront capital, allowing them to access financing sooner.
• Protection Against Rate Hikes: Floating interest rates offer the advantage of refinancing when interest rates decrease, allowing borrowers to capitalise on better market conditions and reduce their monthly payments, which is not possible with fixed-rate loans.
• Flexibility: Unlike fixed-rate loans, floating rate locks can be refinanced if interest rates drop. Borrowers can use more favourable market conditions and lower their monthly payments.
• Suitable for Short-Term Borrowing: If you are someone planning to repay your loan within a shorter timeframe, the initial cost benefits of a floating rate lock can outweigh the potential risks.

Cons

• Uncertainty: The variable nature of floating rates introduces an element of uncertainty into financial planning. Borrowers cannot predict future payments completely, making budgeting more challenging.
• Risk of Rate Increase: The primary concern with floating rates is the possibility of significant increases, which could lead to higher monthly payments and financial strain.
• Higher Potential Payments: Monthly payments can rise over time due to a gradual increase in interest rates, even if they don't reach the rate cap, potentially causing budget constraints and affecting financial flexibility.
• Refinancing Challenges: Refinancing a floating-rate loan can be complex due to the unpredictable nature of future rates. Lenders may be hesitant to offer refinancing options under such circumstances.
• Psychological Impact: The uncertainty surrounding floating rates can cause stress and anxiety for borrowers. The constant possibility of rate hikes can cause mental distress for some individuals.

Conclusion

Floating interest rates can be valuable for borrowers seeking lower initial costs and flexibility. However, the inherent uncertainty and potential for rising rates require careful consideration. Weighing the pros and cons, understanding your risk tolerance, and seeking professional financial advice is crucial before choosing a floating-rate loan.

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