Floating rate loan

A fixed rate loan locks the interest rate for the entire duration, so the borrower knows the exact cost from day one. It is useful when rates are low and the borrower wants to lock them in.

A variable or floating rate loan does not. Its rate changes or gets reset periodically with changes in the benchmark rate to which it is linked. That benchmark can be an external one such as the repo rate, or an internal bank benchmark such as the MCLR.

Borrowers prefer floating rate loans for long-term borrowing, especially when they expect rates to fall over time. Most long-term loans are of this nature, and the workbook notes that banks now usually show their floating rate loans rather than fixed rate loans, because in a fixed rate loan a rise in rates in the economy squeezes the bank's margin.

What to check (4.12).

• The benchmark. External benchmarks like the repo rate are transparent. Internal bank benchmarks often do not change as quickly as rates in the economy, because transmission is slow. This works both ways — in a rising rate scenario, higher rates also come through quicker on an external benchmark.
• The reset period. A very long reset period, say a year, means rate cuts reach the borrower late; in a rising rate environment the same delay is a benefit.

When the rate changes (4.13): change the EMI or change the tenure?

• Keep the EMI, change the tenure. The EMI was chosen to be affordable given income and savings, so keeping it steady is easier to track and avoids distress when rates rise.
• Change the EMI. If rates have fallen significantly, the tenure would have come down quite a bit, and a one-time EMI reduction can reset the working. When EMI pressure is high, a rate change can be used to lower it.

The workbook's numbers (4.11). A Rs 10 lakh loan over 10 years, monthly rest:

A higher rate means more of every EMI goes to interest from the very first payment.

The EMIs are the workbook's; the tenure figures are computed here.

Rekha takes the workbook's loan: Rs 10,00,000 at 7% for 10 years, EMI Rs 11,610. Suppose the benchmark moves right at the start.

Rates rise to 9%.

If her budget has no room for another Rs 1,057 a month, the workbook's preference for keeping the EMI steady protects her. The cost is paid in time instead.

Rates fall to 5%.

Keeping the EMI when rates fall is effectively an automatic prepayment. Lowering it frees cash flow.

Fixed instead? Had she locked 7% fixed, neither scenario would touch her — no gain when rates fall, no pain when they rise. That certainty is what a fixed rate loan buys.

Chapter 4 (Debt Management and Loans): 4.7.1 and 4.7.2 define fixed and floating rate loans; 4.11 shows repayment schedules at different rates using PMT, PPMT and IPMT; 4.12 lists benchmark and reset period among loan-evaluation criteria; 4.13 covers the EMI-or-tenure choice. Expect conceptual questions on when each loan type suits a borrower and on external versus internal benchmarks, and numerical ones on how the interest share of the first EMI changes with the rate.

• Floating rate loans suit borrowers who expect rates to fall; fixed rate loans suit borrowers who want to lock in low rates.
• External benchmarks transmit changes faster in both directions — cuts and rises alike.
• A long reset period delays both rate cuts and rate rises.
• Keeping the EMI when rates rise lengthens the tenure; keeping it when rates fall shortens it.
• A higher rate shifts the first EMI towards interest: at 9% the first EMI is Rs 7,500 interest and Rs 5,167 principal; at 5% it is Rs 4,166 interest and Rs 6,440 principal.
• Name check. The workbook expands MCLR as "Marginal Cost of Lending Rate"; RBI's full name for it is Marginal Cost of Funds based Lending Rate. The abbreviation is what the paper uses.