Fixed vs Floating Interest Rates on Loans. Know what they are?

Understanding loan interest types is important. This blog explains fixed and floating interest rates in simple terms, helping you choose the best option based on your needs and situation.

What is a Fixed Interest Rate?

A fixed interest rate is a constant rate charged on a loan or investment. It remains constant over time, providing predictability in repayments and returns. This type of interest is commonly used in personal loans, fixed deposits, and mortgages. The formula to calculate simple interest is:

Simple Interest (SI) = (Principal × Rate × Time) / 100

Where:

Principal is the initial amount borrowed or invested.

Rate is the annual interest rate.

Time is the period in years.

Example: Wasim's Loan

Wasim borrows ₹10,000 at a fixed interest rate of 5% per annum. Over three years, he pays ₹1,500 as interest, making the total repayment ₹11,500. Fixed interest rates facilitate financial planning due to their predictability.

What is a Floating Interest Rate?

A floating interest rate, also known as a variable rate, is an interest rate that can change over time. It is usually linked to a benchmark rate, such as the Reserve Bank of India's (RBI) repo rate. When the benchmark rate changes, the floating interest rate adjusts accordingly. 

This means that the amount of interest you pay on a loan can go up or down during the loan period. Floating interest rates are common in home loans and can be beneficial when market rates are expected to decrease.

Example: Aryan's Home Loan

In this example, Aryan takes a home loan of ₹5,00,000 with a floating interest rate. The interest rate changes each year based on the RBI's repo rate. As the repo rate increases or decreases, Aryan's interest payments adjust accordingly.

Fixed Interest Rate: Stability and Predictability

A fixed interest rate remains constant throughout the loan or investment period, offering stability and predictability. This consistency enables individuals to plan their finances effectively, as repayments do not fluctuate with market changes. 

Read More - Interest Rates Could Affect Your Next Loan
 

Such rates are particularly beneficial for those who prefer certainty in their financial commitments.

Example: Nitin's Fixed Deposit

Nitin invests ₹1,00,000 in a fixed deposit at an annual interest rate of 7% for 3 years.

Over 3 years, Nitin earns a total interest of ₹22,504. The fixed rate ensures he knows his returns in advance, aiding in financial planning.

Floating Interest Rate: Flexibility with Market Movements

Floating interest rates offer borrowers the flexibility to benefit from market rate reductions. When benchmark rates, such as the Reserve Bank of India's (RBI) repo rate, decrease, borrowers with floating rates experience lower Equated Monthly Instalments (EMIs), leading to potential savings. 

However, if benchmark rates rise, EMIs can increase, posing a financial challenge. This variability makes floating rates suitable for those anticipating stable or declining interest rates.

Example: Manish's Home Loan

Manish secured a ₹15,00,000 home loan with a floating interest rate pegged at 1.5% above the RBI's repo rate. As the repo rate fluctuated over four years, his loan interest rate and EMIs adjusted accordingly. 

Also Read -  Personal Loan Interest Rates
 

This flexibility allowed Manish to benefit from lower EMIs during periods of reduced benchmark rates.

Choosing Between Fixed and Floating Rates

Choosing between fixed and floating interest rates depends on your financial stability and risk tolerance. Fixed rates offer predictability, making budgeting easier, but are usually higher. Floating rates start lower but can fluctuate with market conditions.

Harsh, a student from Bengaluru, took a ₹5,00,000 education loan for 5 years. He compared fixed and floating interest rates:

With a fixed rate, Harsh pays ₹10,624 monthly, totalling ₹6,37,440 over 5 years. With a floating rate starting at 8%, his EMI is ₹10,139, but if rates rise to 12%, EMI increases to ₹11,122, totalling up to ₹6,67,320.

If Harsh prefers stability and can afford higher payments, a fixed rate suits him. If he anticipates stable or falling rates and can handle variability, a floating rate may save money.

Conclusion

Fixed rates stay the same, making planning simple. Floating rates change with the market, which may save or cost more. Pick based on your needs and risk tolerance.

FAQs

1. What is a fixed interest rate?

A fixed rate stays the same for the entire loan, making repayments predictable.

2. What is a floating interest rate?

A floating rate changes with the market, so repayments can go up or down.

3. Which is safer, fixed or floating?

Fixed is safer for budgeting, but floating may save money if rates fall.

4. When should I choose a floating rate?

Choose floating if you expect interest rates to drop or can handle changes.

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LoansJagat Team

We are a team of writers, editors, and proofreaders with 15+ years of experience in the finance field. We are your personal finance gurus! But, we will explain everything in simplified language. Our aim is to make personal and business finance easier for you. While we help you upgrade your financial knowledge, why don't you read some of our blogs?