Floating Interest Rates: A Complete Overview

    Updated on: 11 Aug 2022

    Students going abroad usually rely on education loans. The interest rate and payable interest amount thereby plays a pivotal role in the overall structure of the loan. The loan applicants take special care while choosing the right interest rate type provided by different banks and NBFCs. However, the amount is so high that students cannot ascertain whether to go with Fixed interest rates or Floating interest rates. So let’s understand what is a floating interest rate and see which interest rate a student should take by analyzing the pros and cons of these interest rates.

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    What are fixed and floating interest rates?

    Fixed Interest Rates: In Fixed Interest Rates, the rate of interest is fixed. Yes, there is no hidden meaning to it, and it’s as simple as that. The rate of interest fixed at the time of taking the loan is what you will have to pay for the entire duration of the repayment period. There are no alterations irrespective of anything happening in the market. 

    Floating Interest Rates: Floating interest rates, as evident from their name, has a floating nature and depends on the market forces. The interest rate is not fixed, and it may increase or decrease multiple times in the entire duration of the repayment period. It's the RBI that determines the base rate depending on market dynamics, and the interest rates are pegged to the base rates.

    Since fixed interest rates are simple and don’t need much deliberation, we will put our focus on floating interest rates. Floating rates are complex, and not every banker is interested in explaining all the relevant aspects, so here we will give a complete perspective on Floating interest rates. 

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    Why do borrowers choose floating interest rates?

    The floating interest rates give us the liberty to take advantage of things happening in the market. For instance, if the RBI decides to flush money in the market and encourage banks to lend more, you are going to get a great deal out of it. The lowered interest rates will be applicable until the next revision cycle, which is usually yearly and quarterly or half-yearly. The decreased rates of interest make the Floating rates more lucrative than fixed interest rates, wherein you have to pay at the same rate of interest.

    However, there is a downside to it too. There are some instances when RBI pursues a policy wherein they may increase the base rate due to prevailing market conditions. But one thing that should be clear in your mind is that by “market conditions”, we are not referring to stock market-like conditions. It’s about the overall picture of the economy, which doesn’t vary absurdly in a sporadic manner.

    What is the role of MCLR in floating interest rates?

    Marginal Cost of Funds Based Lending Rate, commonly referred to as the MCLR, is the minimum rate of interest below which banks can’t lend. The RBI introduced it to make the loaning process more democratic. In the past, there were several instances when banks were lending only to a select few customers at lowered interest rates. To counter that, RBI came up with MCLR. 

    Since banks can’t lend below MCLR, so keeping that in mind and making it coherent to their lending process, they calculate the MCLR every month. For loans sanctioned in a particular month will be on some MCLR, and in successive months, the MCLR can be different for other borrowers. So the cost of funds decides the base rates charged by the banks, and it can have varying effects on borrowers. 

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    How does RBIs Repo Rate affect the MCLR?

    RBI is the banker’s bank that lends money to the banks. The rate at which banks can make money from the RBI by selling securities, in case of any shortage of funds, is known as the Repo Rate. So MCLR being linked to the Repo Rate will have a direct consequence on loan. A cut in repo rate will make your interest rate less, but an increment in repo rate may end up increasing the interest rates. MCLR also depends on other factors like operating cost, cost of funds, loan tenor(duration of the loan), etc.

    Up to what extent floating rates can affect the interest rates?

    Students take loans, and if they choose floating interest rates, then they will have repo-based or MCLR based interest rates. The information is provided by the bank beforehand if an applicant wishes to choose Floating Interest Rates. So the loans are structured like MCLR+ A% interest rate or Repo Rate+ A% interest rate. Here, the “A” is constant, known as the premium percentage, and the MCLR or repo-based rates keep changing at certain intervals. 

    For instance, if an applicant takes a loan at 11% MCLR and A(which is constant)= 3%, then your interest rate will be 14%. But if RBI decides to lower the repo rate to inject some liquidity in the market, and the MCLR drops to 9%, then your new interest rate will be 12%. So it’s a matter of market conditions and RBIs repo rate. But as cautioned earlier, it is not like a stock market; rates don’t change abruptly and unevenly. So, floating rates can be beneficial for long-term loans, as paying at a fixed interest rate may increase your overall repayment amount.

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    What is the reset period? How often does it change?

    The reset Period is the time period on which the interest rates will be reset based on the methods explained above. The bank decides the reset period, and it is a must for the borrower to carefully read the documents and ascertain that the reset period is acceptable to them. It is clearly mentioned in the sanction letter or the loan agreement. The rules pertaining to the reset period vary from one bank to another, and there is no uniform rule per se as far as the reset period is concerned.

    Some banks give the reset period of one month, while most of the banks keep the reset period to one year. The rationale behind keeping a long reset period is that the benefit of a lower interest rate can be transferred to a borrower for a relatively long time span. But in a long reset period, there is a downside that if the rates increase, the borrower has to pay a higher interest rate for a relatively long duration. So banks keep both the factors in mind, but given the risk associated with floating interest rates, the benefits are more, and if one wants to reap the benefits of lower interest rates, then they might have to pay a relatively high interest at certain instances. 

    What’s the range of variation in interest rates?

    The range of variation hardly varies from 0.25%-0.50%. Most banks nowadays provide floating exchange rates for a reset period of one year. So every year, the rate of change that is witnessed is not an abrupt number; rather, a very minimal change. The MCLR rates only change, not the premium percentage. So if at all the rates have to change, it’s that part of the loan which is decided by the RBI, not the one which the banks decide. 

    In a nutshell, if your overall interest rate was 13.50%, then it can barely float between 13.25%-14.0%. But a decreased rate of interest rate can help an applicant in saving a considerable amount in interest payments. Since loans for abroad education run in crores, even a slight decrement in interest rate can bring a big difference in the final amount. 

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    Which one is better- fixed or floating interest rate?

    There is no fixed rule to assess which one is better, but most of the students go with the Floating interest rates in recent times. Floating rates give a sense of freedom to the applicant that RBIs policy will make the interest rates low. The flexibility of interest rates reduces the burden on the EMIs, and it comes as a significant relief to students who start earning after completing the course. It also leads to a lot of savings, and this is the reason why now banks give the liberty to switch from fixed to floating interest rates.

    Many students who took the loan at a fixed rate are now switching to floating rates to save considerable money in interest payments. If assessed from the present state of affairs, India is on track to witness colossal growth, and RBI will keep the interest rates lower to encourage lending. So for the times to come, it will be conducive to go with the floating interest rate, but again, everything boils down to an individual’s choice, and it may vary. If a student feels that it is better to go with the fixed interest rates, then even that is not a bad choice, but the recent trends have certainly swayed in favor of floating interest rates.

    Understanding the interest rates in depth can be a difficult task for many students. GyanDhan can help you differentiate and choose the loan product with the best interest rates. All you need to do is to check your loan eligibility and our counselor will get in touch with you to present you with the best possible loan options according to your financial and academic profile. Contact GyanDhan now and leave all your education financing related worries aside!

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