Home loan borrowers can now switch from floating rate to fixed rate and vice-versa. Which is better for you?

The Reserve Bank of India (RBI) recently released a set of FAQs to clarify its circular on 'Reset of Floating Interest Rate on Equated Monthly Instalments (EMI) based Personal Loans' dated August 18, 2023.

Other EMI-based loans, such as consumer credit, education loans, and loans given for investment in financial assets, also qualify for this benefit.

Options for borrowers

The RBI has asked lenders to mandatorily offer the option of fixed interest rate-based products in all EMI-based personal loan categories.

"REs have to mandatorily offer fixed interest rate products in all equated installment-based personal loan categories," the RBI said.

Further, the central bank has asked lenders to provide the following three options to borrowers whenever there is a reset of interest rates for an entire class of borrowers, in a particular loan category, due to an increase in their respective benchmark rates:

1. Option to either increase the EMI or increase the number of EMIs while keeping the EMI unchanged or a combination of both.

2. Option to switch to fixed interest rate for the remaining portion of the loan.

3. Option to prepay, either in part or in full, at any point during the remaining tenor of the loan.

Flexibility to switch

The central bank has clarified that a customer must have the flexibility to switch from a floating rate loan to a fixed rate loan or vice versa after paying applicable charges. Lenders are required to specify the number of times a borrower can switch their options during the loan tenor.

"The intent of the circular is to allow flexibility to the customer to switch from floating rate loan to fixed rate loan or vice versa subject to applicable charges. The RE is required to specify the number of times a borrower will be allowed to exercise the switch option during the tenor of the loan under its Board approved policy," the RBI said.

The above benefit will apply to all EMI-based personal loans, irrespective of whether they are linked to an external benchmark or an internal benchmark of a bank.

Floating rate vs fixed rate: Which is better?

Borrowers may benefit from switching to a fixed-rate loan when the interest rate offered by the bank is very low. However, this is rarely the case. Banks generally charge higher interest on fixed-rate loans compared to floating-rate loans.

The EMI of floating-rate home loans is linked to an external benchmark, such as RBI's repo rate. The EMI of such a loan can change whenever there is a revision in the external rate.

For instance, the EMI goes up when the RBI increases the repo rate. And, when the RBI cuts the repo rate, the EMI goes down.

In contrast, the monthly EMI in a fixed rate-based home loan is set for the entire tenure of the loan.

A fixed-rate home loan can help during rising rate regimes, but borrowers won't benefit if the standard lending rates fall.

In the coming months, the central bank is expected to reduce the repo rate in a bid to combat the slowdown in the economy. This will lead to a reduction in interest rates and EMIs of floating-rate loans.

The RBI increased the repo rate by 250 basis points (2.5%) from May 2022 to February 2023. Since then, the rate has remained unchanged at 6.5%.

According to Dr Soumya Kanti Ghosh, group chief economic advisor at the State Bank of India, the central bank may reduce the repo rate next month.

"We expect RBI to cut rates in February 2025 cumulative 75 bps," Dr Ghosh wrote in the Ecowrap report published by SBI Research last month.

Therefore, the better option between the two may vary depending on the circumstances at any given time.

For instance, amid expectations of rate cuts by RBI in the coming months, borrowers are likely to benefit more by staying in the floating-rate loans.