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Choosing between a fixed and floating interest rate can be difficult choice. It’s important that you consider both, weigh the pros and cons and then make a decision. The following are the factors to consider before choosing the interest rate while taking a loan.
Fixed Interest Rate
Fixed interest rate means that you will be repaying the loan in fixed equal installments for the agreed fixed term. Fixed rates are priced higher than floating rates, if future interest scenario is on a raising trend. If the difference is not much, depending on your preference and need, you can opt for floating or fixed rate. Flat interest rate means not fixed interest means an interest rate that is calculated on the full principal amount of the loan throughout its tenure without considering the monthly EMIs made, which gradually reduces the principal amount.
Another drawback is that in case the interest rate decreases, you will not be able to take advantage of the reduced rates and will have to continue paying the same amount, since the rate of interest remains same for the agreed term.
In the case of flat interest which is different than fixed interest concept, if you take a loan of Rs 1, 00,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay: Rs 50,000 as interest.Thus total 1,50,000 (principal + interest ) will be recovered in 60 EMIs which means Rs 2,500 per month.
Pros of Fixed Interest Rate
Cons of Fixed Interest Rate
Fixed interest rates don’t allow the lender to charge higher interest if the market rate increases. On the other hand if the interest rate decreases that benefit is not passed on to the borrower with fixed rate of interest.
Floating/Reducing/Diminishing Interest Rate
Floating interest rate varies with the market scenario on interest. EMI can change depending upon change in the floating rate.It can be favourable if the rate falls and unfavourable if the rate increases. Any unpaid interest will be added to the principal attracting interest charge. After every EMI payment, the outstanding loan amount gets reduced. Therefore, the interest for the next month is calculated only on the outstanding loan amount.
If you take a loan of Rs 1, 00,000 with a reducing rate of interest of 10% p.a. for 5 years, then your EMI amount would reduce with every repayment. In the first year, you would pay Rs 10, 000 as interest; in the second year you would pay Rs. 8,000 on a reduced principal of Rs. 80,000 and so on, till the last year, you would pay only Rs. 2,000 as interest. Unlike the fixed rate method, you would end up paying Rs. 1.3 lakh instead of Rs. 1.5 lakh.
Pros of Floating/Reducing/Diminishing Interest Rate
Floating rate of interest so long as they remain lower than the fixed interest are beneficial to the borrower. As opposed to fixed interest rates the rate of interest will be normally lower in case of floating interest rates. In India, the floating interest rates range between 9.85% and 11.75% rate of interest varies from bank to bank.
Loans with lower interest rates means the interest outgo will be lower and to that extent the borrower can save interest.
Cons of Floating/Reducing/Diminishing Interest Rate
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