The rates on SBI floating rate loan were reduced sharply earlier this year.

However, if you are only a few months into the loan then the penalty for refinancing can be stiff.

For such people, the only option available is to prepare a programme of prepayment to clear the loan in five to seven years.

That brings us to the suitability of floating rate loans.

Floating rate - suitability

Floating rates are, inherently, suitable only for those who want, and have the ability, to repay loans within five-seven years.

A floating rate loan is taken when the probability of a decline in interest rate is huge.

As the interest rate on floating rate products is lower than that of fixed rate products, the purchaser benefits in the form of lower monthly payments initially.

If interest rates do go down, the purchaser benefits even more in the form of still lower monthly payments. The purchaser will also own the property sooner if the loan is prepaid within five-seven years. In fact, decline in interest rates usually has a beneficial impact on property prices.

With complete ownership, the purchaser can sell the property for a price higher than at which it was bought.

What if the interest rate rises? If rates do rise, then the purchaser's ability to prepay the loan will come to the fore. By repaying the principal amounts faster, the purchaser can reduce the impact of the rise in interest rate.

In a 15-year floating rate loan, the purchaser leaves himself open to too many risks. Interest rates can rise and property prices can fall. The ability of the purchaser to honour monthly payments may also change.

Overall, it is not a suitable option for a person who does not have the ability to repay loans within five-seven years.

Rate shocks - not expected

For those locked into floating rates, there is a positive aspect to the whole issue. Rate shocks that will significantly affect their plans are not expected in the near-term.

In the event of any liquidity crunch, interest rates may at best inch upwards by half a percentage point to one percentage point. Substantial increases in interest rates are not expected.

Consider an alternative scenario. The yields on 10-year US government security is now about 4 per cent while the yields of a 10-year Indian government security is about 5.75 per cent.

The difference is about 1.75 percentage points. In contrast, the interest rate on a 15-year housing loan is about 5.5 per cent while in India it is about 9.5 per cent.

The difference is four percentage points. This difference appears quite high and is likely to narrow. So, even if interest rates in the economy do rise, the rates for housing loan may stay where they are or even decline. However, this scenario might take years to materialise.

In any case, a new home loan purchaser who has bought into a floating rate loan need not panic. There is still time to plan a programme of prepayment. Prepayments have another benefit too.

Amounts prepaid will save interest of about 9.5 per cent. After considering any reduction in tax benefits, the amount saved would work out to 7-8 per cent. No low-risk investment opportunities are available that fetch such a high post-tax return.

So, prepayments provide double benefits — higher returns for the cash surplus and protection against a rise in interest rate.

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