In my previous article on house loan: fixed v/s floating, it appeared as if the readers have got the impression that I am for fixed home loan only. It’s not the case. As rmathew and nickp2 have rightly pointed out in the comments on my previous post, , that even if the interest rates are lower and you take fixed rate home loan, there is no such guarantee that the bank will not change the rates later. There may be a clause in the loan agreement, even with fixed interest rates, that banks may raise the fixed interest rates if the market situations change drastically. So ultimately, the loan borrower is in a fix, either this way or that way.
Take this practical situation:
Let’s say the loan are available for cheap i.e. the interest rates are low. A fixed rate home loan is available for 7% while a floating rate home loan is available at 6.5%. Why is fixed rate 0.5% higher than floating? The reason is that in fixed rate, the risk, to a certain extent, is passed on to the bank. In case of floating home loan, even with the slightest of rate changes, the bank will immediately change the rate for the floating rate borrower. But for fixed rate borrowers, they usually do it when there is a significant change in the interest rates. Like 7% in 2003 and now 12% in 2007. Hence, when one takes fixed rate home loan, he has to pay for the risk – ultimately, the bank is passing on the risk to the customer of fixed rate loan, by charging a higher interest rate as compared to the floating rate loan.
To understand it clearly, have a look at the interest rate offered on fixed deposits of one of the Indian banks:
| PERIOD | INTEREST RATES ON DOMESTIC DEPOSITS | |
| DEPOSITS | Interest Rate on Deposits Below Rs 15 lakhs | |
| 7 days to 14 days | 0 | |
| 15 days to 45 days | 5 | |
| 46 days to 60 days | 5.5 | |
| 61 days to less than 3 months | 5.5 | |
| 3 months to less than 4 months | 6 | |
| 4 months to less than 6 months | 6.15 | |
| 6 months to less than 9 months | 7.25 | |
| 9 months to less than 1 year | 8 | |
| 1 year to less than 2 years | 9.5 | |
| 2 year to less than 3 years | 9 | |
| 3 Years to less than 5 years | 8 | |
| 5 Years upto 10 years | 8 | |
In general, people believe that the longer the duration of your deposited money, the better interest rates will be offered by the bank. It is true to a certain extent, because the longer the duration of your deposit, the more time your money lies with the bank, the more time bank will have to use your money and earn profit and hence it can offer you more percentage returns in terms of higher interest rates.
However, banks cannot simply keep on giving higher interest rates depending upon the length of the deposit duration. The reason is that banks are also taking a risk by promising you a return. Suppose today, the banks promise you 12% return on 5 year long deposit and you deposit 1 million with the bank. However, in the 3rd year, the interest rate fall to the level of mere 4%, then the bank will be at a big loss if it continues to give you 12% returns. Hence, the banks have to cover this risk.
Have a look at the table above. As it can be seen, starting from 7 days to 1 year deposit period, the bank interest rates are growing consistently – from 0% to 9.5%. However, from 2 year it again starts to dip. For 2 years it is 9%, while for more it is down to 8%. This is a practical example of how the banks limit their long term interest rate risks.
Though difficult, to a certain extent it is possible to define certain ranges for interest rates for upto a year, as interest rates do not change everyday (like stock prices do). But forecasting beyond that, it becomes difficult. Hence, the interest rates offered for long term than 1 year is low compared to what is offered for upto 1 year.
Continue to Part II
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