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Business News/ Money / Personal loans: Fixed vs variable interest rates and how to decide between them

Personal loans: Fixed vs variable interest rates and how to decide between them

When it comes to personal loans, grappling with the decision between fixed and variable interest rates is commonplace. Ultimately, the optimal choice hinges on your unique circumstances.

Importance of using an EMI calculator while getting a personal loanPremium
Importance of using an EMI calculator while getting a personal loan

In the realm of personal loans, the interest rate structure stands out as a crucial consideration. Borrowers typically encounter two primary options: Fixed and variable interest rates, each presenting its array of benefits and considerations. 

Here's an overview of the main distinctions to assist you in determining which option may be more suitable for your needs:

Fixed interest rate

The interest rate on your loan remains constant throughout the entire loan duration. Choosing a fixed interest rate for your loan offers several benefits, including:

  • Predictable payments: Your monthly payment amount remains consistent throughout the loan term, facilitating easier budgeting.
  • Interest rate security: You are shielded from potential interest rate increases in the future.

However, there are drawbacks to selecting a fixed interest rate for your loans, which include:

  • Possible higher initial rate: Fixed interest rates might be marginally higher than variable rates at the outset, particularly if you possess good credit.
  • Missed opportunities for rate reductions: In case interest rates decrease during your loan tenure, you won't reap the advantages of the lower rate.

Variable interest rate

The interest rate on your loan is subject to change based on an underlying index or benchmark rate. There is no doubt that choosing to repay your personal loan at variable interest rates has certain drawbacks that include:

  • Possible lower initial rate: Variable rates may be lower than fixed rates initially, particularly if you possess good credit and anticipate low interest rates to persist.

Many borrowers are drawn to variable interest rates for personal loans in anticipation of potential future decreases. However, there are drawbacks to this decision, including:

  • Unpredictable payments: Fluctuations in the interest rate can lead to changes in your monthly payment amount, making budgeting more challenging.
  • Interest rate risk: If interest rates increase, there is a risk that your monthly payment and total loan cost could rise significantly.

Deciding between fixed and variable rates

Deciding between a fixed or variable interest rate for your loan hinges on your risk tolerance, financial objectives, and the prevailing economic conditions. Here are some factors to contemplate:

  • Risk tolerance: Opting for a fixed rate provides stability, as your interest rate and monthly payment remain unchanged for the loan's duration. This is advantageous if you prefer consistency and desire predictable budgeting. Variable rates, however, can fluctuate, possibly reducing your payment if rates decline, but also increasing it if rates rise. Hence, assess your comfort level regarding potential payment fluctuations.
  • Loan tenure: Interest rate fluctuations have a more pronounced impact on longer loan terms. If you intend to repay the loan swiftly (shorter term), the interest rate may not be a major consideration. Conversely, with a longer term, opting for a fixed rate shields you from potential future rate increases.
  • Market interest rates: Typically, when there's an anticipation of rising interest rates, opting for a fixed rate secures a lower rate at present. Conversely, if there's an expectation of rate reductions, a variable rate could be advantageous. However, it's important to note that these projections are educated guesses, and economic forecasts are not infallible.
  • Financial goals: Are you emphasising consistent budgeting and predictability (fixed rate)? Or are you seeking the possibility of reduced payments if rates decrease (variable rate)?
  • Prepayment penalties: Certain loans come with prepayment penalties, discouraging early loan repayment. This could pose a drawback with a variable rate if interest rates increase and you intend to refinance or settle the loan sooner.

By taking into account these factors, you can select the type of interest rate that aligns best with your financial circumstances and risk tolerance.

Frequently Asked Questions (FAQs)

Q. What are the average interest rates for personal loans?

The interest rates on personal loans can exhibit significant variance, typically falling between 10% and 24% per annum in India. The precise rate offered hinges on factors such as your creditworthiness (credit score, income), loan amount, loan tenure, and the lender's guidelines.

Q. How does interest accrue on a personal loan?

Personal loans commonly employ the reducing balance method. Interest is computed solely on the remaining loan balance, which diminishes with each installment. Consequently, as you repay the loan, the interest amount decreases over time.

Q. Is it possible to negotiate the interest rate for a personal loan?

Though less prevalent compared to other loan types, negotiating a slightly lower rate on a personal loan might be feasible, particularly if you possess a high credit score or maintain a robust relationship with the lender.

Q. How can I secure the most competitive interest rates for a personal loan?

Discovering the optimal personal loan interest rate entails research and comparison shopping. Below are effective strategies to assist you in securing the most competitive rate:

  • Explore various lenders: Compare interest rates offered by different banks, NBFCs (Non-Banking Financial Companies), and online lenders.
  • Utilise online comparison tools: These tools facilitate quick comparison of rates and terms from multiple lenders.
  • Assess your credit score: Understanding your credit score provides insight into the rates you may be eligible for.

Q. When does a variable loan become costlier than a fixed loan?

Variable interest rate loans typically start with lower interest rates compared to fixed-rate loans, especially at the loan's outset. However, as interest rates escalate, loan repayments also rise. If interest rates surge rapidly, variable-rate loans may become more expensive than fixed-rate loans. Borrowers, particularly those who are overcapitalised or already near their repayment capacity, face heightened risk in such scenarios.

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Published: 29 Mar 2024, 11:25 AM IST
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