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Learn More About: Benefitting from Floating Interest Rates

Updated on June 23, 2015

Are you planning to buy a property in UAE? It’s very easy to do so given that a number of reputed banks in UAE offer home loans for UAE nationals and expats at attractive rates of interest. However, before you proceed to take a loan, it is advisable that you have the basic understanding of different interest rates charged by banks and how they work. An interest rate is the amount charged by your bank for lending you a particular amount of money. Interest rates are normally charged at yearly, monthly and daily basis. However, it depends on your lender or bank.

Know about different interest rates

Interest rate serves as a compensation for lending, as the bank could have invested that fund somewhere else rather lending it to you. Normally, banks in UAE offers different types of interest rates for loans which include simple interest rate, compound interest rate, fixed interest rate and floating interest rate. Simple interest is calculated on the original principal amount whereas compound interest is a kind of interest on interest; it is calculated on the principal amount as well as the accumulated interest of previous periods. A fixed rate of interest is stable. The same rate of interest continues for the entire tenure of your loan. On the other hand, floating rates fluctuate based on the market condition. Knowing how much interest you will pay on your debts always helps, especially when you take a huge sum of money for a longer tenure. This helps you plan your finance in a systematic way and set your future financial goals.

What is a Floating Interest Rate?
What is a Floating Interest Rate?

What is a floating rate of interest?

So, what is a floating rate of interest? As the name suggests, it is a kind of interest rate that floats or varies based on the economic condition and in relation to the prime lending rate of a bank. Loans offering floating rate of interest are linked to a prime lending rate. So, when the prime lending rate changes, the floating rate also changes. Floating rate of interest is also known as adjustable or variable rate of interest because it varies over the duration of the loan tenure. Loans offering floating rate of interest is very common in the banking industry. Mostly, people opt for floating rate of interest when they purchase properties such as home and car. You can take the same loans by opting for a fixed rate of interest. In that case, you will have to pay the same rate of interest for the whole tenure of your loan. Normally, a floating rate loan costs you less than a fixed rate loan. In a floating rate loan, the interest rate remains fixed for a particular period of time, say for 5 to 7 years. But, going forward the rate of interest changes and gets readjusted annually.

While choosing the floating rate of interest for your home loan or car loan, you also need to understand the factors that trigger changes on you loan interest rates. These factors include inflation, bank’s liquidity retirements, demand for housing loans, political and economic changes etc. These factors may affect the prime lending rate of a bank which in return affects the floating interest rate.

So how does floating interest rate work?
So how does floating interest rate work?

How does floating interest rate work?

It is already mentioned that floating rate of interest is dependent on the prime lending rate of a bank. As the prime lending rate goes up, the floating rate also goes up. In order to understand how a floating rate of interest works, let’s take this example. You want to take a home loan of AED 3.5 million from a particular bank in UAE to purchase a house over there. Your bank offers you a floating rate home loan at prime lending rate plus 6%. Now, if your bank charges 4 % as prime lending rate, then your total interest rate will be 11%. However, going forward, your bank may reset this total floating rate of interest when its prime rate changes. If its prime rate goes up, your home loan interest rate will also go up and if the prime rate comes down, your total interest rate will also come down.

Also, you can switch between a floating rate of interest and a fixed rate of interest. Normally, people shift from floating to fixed rate of interest when floating interest rate goes up.

Fixed vs Floating rates of interest

As we already know that interest rates in floating rate loans differ as per the market condition. It moves up and down with the changing economic condition and likewise EMIs under it also fluctuates. Floating rate loans tend to be less expensive.

But, in case of a fixed rate loan, you cannot request for any change in your interest rates. The same interest rate determined by your lender or bank will continue to the remaining tenure of your loan. Sometimes, fixed rate loans seem to charge higher rates of interest than floating rate loans. However, with fixed rates of interest, you can have a transparency as to how much interest you need to pay towards your loan repayment.

Fixed vs Floating Interest Rates
Fixed vs Floating Interest Rates
Loan Parameters
Fixed Interest Rate
Floating Interest Rate
Interest Rate
Fixed throughout the tenure of loan.
Changes in response to market condition.
EMI
Fixed throughout the tenure of loan.Fixed
Changes with change in interest rate.
Amount
Fixed rate loans are expensive.
Floating rate loans tend to be less expensive.

Benefits of opting for floating rate of interest:

It's important that you know the benefits of floating interest rates so that you can take right decision when applying for your property loan. You can enjoy the following benefits by choosing floating rate of interest for your home/car loan:

  • Floating rate loans are cheaper than the loans charging a fixed rate of interest. For example, if you are applying for a home loan at a floating rate of interest of 10%. The bank also offers the same amount of home loan at 13% as fixed rate of interest. Going forward, if the floating rate of interest goes up to 3 %, you can still be in profit. No doubt, the floating rate may go higher than the fixed rate of interest, but it will effective for short period of time, not for the whole tenure of your loan. Afterwards, the interest rate will certainly come down.
  • Since, floating rate loans are cheaper than fixed rate loans, you can add to your savings by choosing a floating rate of interest. That’s why a loan offering floating rate of interest is on high demand than fixed rate loans.
  • The most important benefit you can enjoy by choosing the floating rate of interest is that when bank interest rates go down for any reason, you can enjoy the benefit of paying the reduced rate of interest on your loan. A person choosing fixed rate of interest cannot enjoy this benefit. He/she has to repay the same fixed rate of interest every time.
  • Your EMIs will also vary as per the changing rate of interest. It goes up and down when the rate of interest increases and decrease respectively.

Tell us about your choice:

So, now that you know the difference between fixed and floating interest rates, which one would you prefer the next time you take a loan?

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Conclusion:

It is often seen that floating rate loans are very popular among people who want to take a loan for a longer duration, especially a home loan. A major portion of home loan applicants opt for floating rate of interest so that they can take the advantage of fluctuating and low-cost interest rates. Obviously, a higher interest rate welcomes lesser borrowing and a lower interest rate encourages higher borrowing. However, it is always advisable to study the financial market and compare loans and interest rates offered by various banks before you take the final call. Because, getting a loan is very easy, but choosing the best and competitive rate of interest is a difficult task, and it needs a lot of homework on your part.

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