Fixed Rates: Should You Bite The Bait?

Almost everybody had expected the RBI to take a pause in hiking key interest rates. However, these expectations have been dealt a cruel blow. The central bank dashed all hopes of a respite, by increasing the rates by 25 basis points yet again, in what was the 12th hike since March 2010. While there is again an expectation building up that this will be the last hike before interest rates begin to go down, the future course of the RBI would actually depend on the ever-pervasive phenomenon of inflation. After all, hasn’t controlling inflation been the sole purpose of the RBI in raising interest rates over the past year or so? While inflations and interest rate hikes are subjects of high finance, these economic events do not fail to touch the common man in one way or the other. One interesting phenomenon that is emerging out of all this drama of higher interest rates and inflationary pressures is the smart marketing strategy of financial institutions, which have now started selling dual-rate loans aggressively.

Banks Playing Smart
Since interest rates in India are appearing to have peaked, financial institutions are rushing in with dual-rate housing loans, hoping to tie-up prospective borrowers at peak rates of interest for a few years more. ICICI Bank first set this ball rolling, by launching home loans with the option of a fixed rate for either the first year or for the first two years. The fixed rate for one year is between 10.5 per cent and 11.5 per cent, depending on the loan amount, and between 10.75 per cent to 11.75 per cent for two years. HDFC Bank followed suit, by unveiling products with fixed as well as floating rates packaged into one loan offer – the plans offer fixed rates for the first three (between 10.75 per cent to 11.75 per cent) or five years (between 11.25 per cent to 11.75 per cent). LIC Housing Finance, too, has joined the game, with its ‘New Advantage 5’ scheme. This product offers a fixed rate of interest for the first five years, and a floating rate thereafter, with an interest rate in the range of 11.15 per cent to 11.65 per cent. Another financial institution, Edelweiss Housing Finance, has also launched two-year and five-year fixed rate loans.

Dual Rates: Comforting or Cunning?
The fixed-floating rate combination gives borrowers, particularly young home buyers, a degree of comfort in the crucial initial years of the loan, when their borrowing capacity is stretched, and they cannot afford too much elasticity in their monthly outgo. For instance, as the average age of home buyers has come down, a typical borrower could very well be in the early stages of his/her career, when he/she takes the decision to purchase the first house. In such a scenario, the individual may borrow from multiple sources, including friends and parents, apart from dipping into personal savings, to make up the margin money. The remaining balance would be financed by the home loan. It is at this crucial stage that the EMIs become critical, and a borrower can ill afford uncertainty in interest rates. Products with a fixed interest rate in the initial years prove useful to this market segment. On the basis of market feedback, the tenure of fixed rates has been increased to as long as three years and five years. This means that by the time borrowers are exposed to the market interest rates, they are well-settled into their jobs, are likely to have benefited from some salary hikes and are able to absorb potential hikes in interest rates.[PAGE BREAK]
Having said so, market experts still feel that consumers must stay away from such plans. “This is not the right time to opt for dual rates, as the interest rate cycle is expected to turn. Hence, it is only a question of time for the floating rate itself to go below the fixed rates offered by these products. So, it is better for customers to tie in to a floating rate loan, rather than to convert to the new dual interest rate products,” says Suresh Sadagopan, Principal Financial Planner, Ladder7 Financial Advisories.

Pankaj Mathpal, Managing Director, Optima Money Managers, says, “Interest rates have almost reached a peak, and would be stable for some time now. Further, these rates would come down in the next 10 to 12 months’ time. In such a situation, it is not a wise move for borrowers to opt for locked interest rates.”

Impact On Consumers
If consumers opt for a dual-rate plan, chances are high that they would not be able to enjoy the advantages if and when the RBI lowers the rates. In fact, there are experts who believe that this policy will lead to customers paying more.

“If a person opts for such a scheme at this point of time, when interest rates are close to peaking out, I would not call it a wise decision. It will be better to opt for a floating-rate scheme now. I would also like to add here, that if a person opts for a one-year fixed tenure, then it makes some sense for him/her. However, this option is available only with ICICI. The rest of the lot, including HDFC and LIC, have three to five-year tenure periods,” says Harsh Roongta, CEO, Apnapaisa.com.

Roongta further adds that he does not feel any sort of inclination towards fixed-rate tenures, as they come at a premium. For example, if the flexible rate is 10.5 per cent and the fixed rate is 10.75 per cent, it is hardly advisable that anyone should go in for it.
Sadagopan seconds this opinion. According to him, those who do not understand that the rate cycle is going to turn and get into these products will end up paying higher interest for the three to five year period.

“If interest rates come down in the next few months, such borrowers will not be able to take the benefit of lower interest rates till the fixed term period is over. Locking the interest rate for three to five years is not at all a wise decision,” adds Mathpal.

Teaser Rates: What The RBI Says
The RBI has recently stated that home loan plans with fixed interest rates in the initial years and floating rates thereafter, will be considered as ‘teaser’ loans. Interest rates that are a mixture of these two (fixed and floating) are thus called teaser rates. If there are rules, they (teaser loan products) will attract additional provisioning. The RBI also clarified that financial institutions are allowed to issue such products, as long as they make necessary provisions for the loans, as laid down by the central bank. However, major lenders ICICI Bank and Housing Development Finance Corporation, who recently issued such loans, refused to classify the rates as teaser rates.[PAGE BREAK]
In this regard, Sadagopan has the following observation to share, “The RBI is worried about the ability of people to service loans when the floating rates kick in later. The anxiety is that if people are paying a certain EMI now, and need to pay a higher EMI in the future due to higher float-ing rates, they may have problems servicing it, and defaults could rise. That is why the RBI frowned on teaser rates, where, in the initial years it was fixed and lower, and in the later years it migrated to a floating rate.”

So, What Should A Consumer Do?
Now, this is something that needs a lot of brainstorming. Many financial experts are of the view that people can opt for dual rates where the fixed-rate tenure is to the limit of one year. After that, it would be a bit risky, and may turn out to be an expensive decision in the longer term. Also, the need of the hour is to conduct some thorough research before opting for any particular loan scheme. Simply going by market reports will not help, as each individual’s requirements and financial needs are different. One must also invest enough time and thought when deciding the tenure of the repayment of the loan amount, as this will have a significant bearing on the interest rates that apply to you.

Mathpal asserts that the rates will stabilise for some time, and it should be around nine per cent in the coming years. In fact, interest rates may even come down further in the long term. So, consumers must make a wise choice now.

Says Sadagopan, “It is difficult to predict how the rates would behave in the long run, though, for an economy that wants to grow, for which infrastructure and housing is a priority sector, I would assume it should be in high single digits.” He also states that the RBI would lower the lending rates in some time, as the interest rates have presently shot up to exceedingly high levels.