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Floating Interest Rate
What is a floating interest rate?
A floating rate is an interest rate that changes with the market or is determined by an index. Throughout the repayment period, the floating interest rate may fluctuate (increase or decrease) multiple times.
The interest rate levied upon by the lending institutes includes a base rate determined by the India's Reserve Bank (repo rate). Along with this repo rate, the lender adds a "spread" (extra interest) to determine the interest rate. This base rate is influenced by several market circumstances. Any change in repo rates is passed along to the borrower and adjusted to reflect the loan's current interest rate. Floating rates might fluctuate often, depending on the conditions of your loan.
How does the floating rate work?
A floating interest rate is a variable interest rate that fluctuates along with the market. Depending on the loan or asset type, the underlying standard rate of interest or index will vary. Financial institutions charge a spread over this standard rate for consumer loans and debt, such as for mortgages, auto loans, and credit cards. The spread depends on several variables, including the type of asset and the consumer's credit score.
Pros and cons of floating rate
Pros
Affordable: Floating rates are variable in the near term since they depend on the market. However, floating rates are less expensive than loans with fixed interest rates. In a system of floating interest, there is no max rate increase permitted.
Pegged to the Repo Rate: The repo rate, at which banks take funds from the Reserve Bank of India, is referred to as being "pegged" to it (RBI). Additionally, variable lending rates are directly linked to the repo rate. Fixed-interest rate debts are more expensive than long-term loans with fluctuating interest rates.
No Prepayment Penalty: As per RBI regulations, lenders are not permitted to impose a penalty on prepayments for loan with floating interest rates.
Cons
Financial Planning: Due to the unpredictable nature of interest rates, financial planning is challenging. Unfavourable market conditions could result in higher premiums, which might affect your monthly budget.
Constantly changing and inconvenient: The unpredictability of floating rates makes it challenging to plan and manage finances. Furthermore, it is challenging to maintain the EMI payments given the fluctuating interest rates. As a result, EMIs with fluctuating rates lack consistency and predictability.
