Back-to-back Loan – Some Major Factors

There are two interest payment options you can select from when applying for a home loan-fixed rate and floating rate.

A fixed rate is where the level of interest is fixed throughout the length of the loan. Generally, most banks keep the rates fixed for a period of up to 5 years.

Some Back-to-back Loan Ideas

A floating rate is where the level of interest is benchmarked against a specific interest rate (usually the bank’s internal rate), and fluctuates according to the benchmark.

Usually, you can strike a floating rate loan at a reduced rate than a fixed rate loan, the difference being around one to two per cent.

Widening The Back-to-back Loan Discussion

Keep the following factors in mind while deciding whether to choose a fixed rate or floating rate: Outlook: When interest rates are high, it makes sense to go in for a floating rate loan, as a drop in rates will benefit you. And if interest rates are low, it is desirable to lock in a lower fixed rate for at least three-5 years.

Stage of life: If you’re a senior citizen, or somebody with a fixed source of revenue, you cannot afford an increase in EMI and should go for a fixed rate loan.

Fixed rate loans aren’t fixed In the world of finance, nothing is certain, especially where the loan segment is concerned. There is a great deal of fine print that needs to be read carefully before action is made because it can come back to haunt the person at some later stage. Investors as well as borrowers in India have experienced this in the past few years and hence this area needs extra attention.

In common parlance, the term fixed rate loan can be separated from the floating rate loan on the basis of the way in which a borrower will pay interest on the loan. In a floating rate loan, the rate paid is related to some other rate, usually a benchmark rate, fixed by the lending institution. Changes in an economy affect the benchmark rate and the borrower also experiences a change in the pace that he/she will pay. As opposed to this a fixed rate loan will have a fixed rate of concern to be paid on it.

This means that the fixed rate will also change; the only difference will become the frequency at which time it will change.

There are two factors that give rise to a change as regards the fixed rate is concerned. In many agreements, the rate is fixed for only a specific duration of time. This time period can be of three years or five years and the level of interest can change after this period is over. After this the lender can once again fix the rate for some extra time duration and this will be achieved based upon the situation prevailing at that time of time. So, if there has been an increase in the rates due to some reason, the fixed rates will be revised upwards and the person can get trapped because the higher rates will then be applicable for the following fixed time period.

This can also happen through a provision that says that in the event of an emergency situation in the economy or massive disruptions in the debt market, the rate of interest might change. What this situation will be isn’t well defined and is open to interpretation. Due to this reason borrowers will always be on the edge. In the event of such a situation, the loan will no longer have the features that the borrowers believed were present initially.

A word of caution All banks lend floating rate loans at a discount to a benchmark rate called ‘Prime Lending Rate’ (PLR). This benchmark rate and the volume of discount are an internal affair for a bank. This can affect a customer.

Let’s look at the movement of PLR and average discount of some private banks: The rates have risen from 8 to 12 per cent in around three years.

While the rates of interest for a new customer have fallen, those for the old customers are still increasing.

So, if you wish to avail of better rates, go in for prepayment and take a new loan. It might be worthwhile in spite of the 2 per cent prepayment fee.

Most private banks have increased the interest rates heavily, whereas public banks have been much more moderate.

Borrowers always find it hard to choose between a fixed rate loan and floating rate loan, and in recent years, they have to consider one more option-fixed floating rate loan.

In this loan type, the interest rate is fixed for an initial period. These later gets converted to a floating one.

What should a customer do? Consider the impact beyond year one while taking the loan. If interest rate for a new loan is deliberately kept low to attract customers, any change can result in a spike in the EMI. This will mean a large discount in the initial year on the prevalent interest rate. The rates mightn’t be in line with the rising trend of interest rates in the future.

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