Fixed vs. Floating Interest: Which One Should You Choose?

Car loans are an excellent way to finance the purchase of a new car. With a number of options available from both banks and other non-financial banking companies, individuals looking to purchase a new car have a plethora of options to choose from. The flexibility in choosing a repayment tenure further adds to its appeal.

As most of us are already aware, the longer the loan tenure the higher the amount paid in interest. And while it might seem like the best choice to go for the lowest EMI option, it usually comes with the lengthiest repayment tenure and a significant amount of the EMI is paid towards interest on the amount borrowed.

A fixed interest rate is one where the rate of interest that is set at the beginning of the loan tenure remains the same throughout the duration of the loan. Fixed interest rates are often chosen by those borrowers who do not want to risk being subject to a fluctuation in interest rates during their loan tenure.

With a floating interest rate, the rate of interest charged on the car loan fluctuates based on market conditions. The interest rate is set based on the Floating Reference Rate (FPR) which is the benchmark rate by which most banks set their floating interest rates for their loan products. The factors that determine the floating interest rate include the benchmark rate, effective rate and the markup or markdown. The effective rate refers to the actual interest charged on the loan and the benchmark rate usually is either higher or lower than the effective rate. When the benchmark rate falls, so does the rate of interest charged on the car loan and when the benchmark rate rises, so do the rate of interest.

There are a number of advantages and drawbacks that come with choosing a fixed rate of interest for your car loan. Some of them are as follows:

• There is consistency in the rate of interest charged throughout the year.
• The EMIs payable during the loan tenure remain the same.
• The changes in the market conditions have no effect on the amount that is paid in interest.
• Choosing a fixed rate of interest on your car loan makes it easier to plan your finances and plan for the future.
• In most cases, the rate of interest charged on a car loan with a fixed interest rate tends to be higher than that of a floating interest rate. This is largely to neutralise any fluctuations due to changes in the benchmark rate.
• When the benchmark rate drops, borrowers who have opted for a fixed interest rate do not get to enjoy the benefit of a lower interest rate.

As is the case with a fixed interest rate, floating interest rates also come with a few advantages and disadvantages. Some of these include the following:

• With floating interest rates, the cost is much cheaper when the loan is initialised as compared to loans with a fixed interest rate. This, in turn, decreases the amount of the EMI until the time the benchmark rises above the fixed rate of interest.
• When the benchmark rate rises, the rate of interest charged on a loan with floating interest increases temporarily.
• When the markets drop, the rate of interest charged on a car loan with a floating interest rate further drops, thereby decreasing the amount of the EMI.
• One of the primary disadvantages of choosing a floating interest rate on your car loan is that it makes it difficult to plan and budget your finances.
• The lack of stability in the rate of interest charged can sometimes result in the borrower paying a much higher rate of interest on their loan at various points in the loan tenure.

Choosing between a floating interest rate and a fixed interest rate depends entirely on the borrower and their financial situation, in addition to the tenure of the loan. A fixed rate of interest makes the most sense for borrowers who are averse to market risk and require stability in their repayment schedule. Furthermore, when the loan tenure chosen is relatively shorter, it is advisable to choose a fixed interest rate.

A floating interest rate is most suitable for borrowers who have a higher risk appetite and are willing to take advantage of the rise and fall of the market conditions. Additionally, if the borrower chooses the longest loan tenure, it is advisable to choose a floating rate rather than a fixed rate of interest.