The Reserve Bank of India (RBI) recently issued detailed guidelines to reset floating-interest rates on Equated Monthly Instalments (EMI)-based personal loans.
About Floating Interest Rate
- A floating interest rate is an interest rate that changes periodically.
- The rate of interest moves up and down, or "floats," reflecting economic or financial market conditions.
- A floating interest rate can also be referred to as an adjustable or variable interest rate because it can vary over the term of a debt obligation.
- The change in interest rate with a floating rate loan is typically based on a reference, or “benchmark”, rate that is outside of any control by the parties involved in the contract.
- The reference rate is usually a recognized benchmark interest rate, such as the prime rate, which is the lowest rate that commercial banks charge their most creditworthy customers for loans (typically, large corporations or high net worth individuals).
- How is floating interest rate calculated?
- A floating interest rate uses a reference rate as the base.
- In order to arrive at the floating rate, a spread (or margin) is added to the reference rate.
- Floating Interest Rate = Base Rate + Spread
- Floating interest rates can be modified quarterly, half-yearly or annually.
- Several factors tend to influence the calculation of floating interest rates. Some of the economic factors are,
- Repo rate
- Government’s monetary policies
- Inflation rate
- Fiscal deficit
- Global and foreign interest
- When is Floating Rate Relevant?
- While applying for a loan:
- Typically, intending borrowers pick a loan with a floating rate when they expect a reduction in the interest rate or a dynamic rate through their loan tenure.
- Additionally, such an interest type enables individuals to make prepayments easily and pay off their debt faster and at a much lower interest burden.
- While investing:
- Individuals can choose investment instruments with floating rates when they anticipate the base rate will be the same, or an expected change will be in their favour.
- Under such situations, the interest earned on investments made either stays the same or is likely to increase.
- While applying for a loan:
- Limitations of Floating Rate:
- The fluctuation of rate is beyond the control of both parties in a contract, namely – the lender and borrower in a lending institution setup.
- Similarly, investors and investment firms have to make their way around the fluctuations to generate earnings while cushioning their capital.
- Even the slightest increase in the interest rate can push loan EMI burden significantly for loan borrowers. It often makes the repayment process challenging and disrupts a functioning financial plan.
- A small decrease in the interest rate generates a return on investment which is much lower than what one had anticipated before. As a result, investors may take a longer time to reach their respective financial goals.
- Both borrowers and investors often find it quite challenging to manage their budget plan and regulate savings when dealing with a floating rate based financial or investment option.
Q1) What is Equated Monthly Installment (EMI)?
An equated monthly installment (EMI) is a fixed payment amount made by a borrower to a lender at a specified date each calendar month. Equated monthly installments are applied to both interest and principal each month so that over a specified number of years, the loan is paid off in full.