Fixed and Floating-Rate Loans: Who Carries a Rate Move

On a fixed-rate loan the rate agreed at sanction does not change, so the lender is left holding any movement in rates. On a floating-rate loan the rate is a published reference plus a fixed spread and it is recomputed on a stated cycle, so the borrower holds it. One event, two contracts, opposite sides. How a rate is benchmarked and how often it resets are set by the Reserve Bank of India.

Interest rates move because of things happening a long way outside any single loan. Nobody at the counter caused the movement and nobody at the counter can call it off. A loan agreement does less about that fact than most readers expect: it cannot remove the movement, and it does not try to. The agreement decides which of the two parties is standing under the movement when it arrives. Every other difference between a fixed rate and a floating rate is a consequence of that single allocation. Everything else is downstream.

What has to be true before either structure makes sense?

Two things, and both are worth saying out loud. The first is that a loan is a promise running in both directions. The borrower promises to pay; the lender promises a price. A promise about price is exactly as binding as a promise about repayment. Treat a loan as a one-sided obligation and the day the lender turns out to be stuck with something arrives as a surprise. The second is that the lender is itself a borrower. Suvarna Commercial Bank Limited, an invented bank, pays for the deposits it holds, and Rukmini Finance Limited, an invented lender, pays for the money it raises in the market. When rates move, both institutions feel it on the side where they pay before they feel it anywhere else.

Put those together and the shape of the question appears. There is a movement, there is a price that was promised, and there is a cost that was not promised to anybody. Whether the promised price follows the movement is the whole of what separates the two structures. A household will recognise the shape immediately. A year of tuition agreed at a fixed monthly figure leaves the tutor carrying whatever happens to their own costs; an agreement to pay whatever the going rate is each month leaves the household carrying it instead. Nobody removed the cost from the world. One of the two parties agreed to stand under it.

What criteria separate a fixed-rate loan from a floating-rate one?

Five, and all five go down before either structure is examined. A comparison that invents its criteria while it runs tends to invent the ones that suit its conclusion. How the rate is arrived at. Whether and when it changes. Which side carries a move in rates. The certainty the borrower can plan on. The machinery that runs at the moment of a change.

The third criterion is the one the other four are downstream of. How the rate is arrived at is a mechanism for deciding whether it follows a movement. Whether it changes is that decision restated. The certainty the borrower can plan on is what is left over once the allocation is made, and the machinery at a change carries the allocation out. A comparison that lists the third criterion third in importance has buried its own finding somewhere in the middle of a table.

What is a fixed-rate loan, taken on its own?

A fixed-rate loan carries a rate agreed at sanctionThe moment a lender approves a loan and writes down its terms. Whatever is agreed then applies from the first payment onward. that applies for the stated period, whatever happens to rates afterwards. The definition ends there, and the phrase whatever happens to rates afterwards is doing more work than it looks. Read that phrase twice. A fixed rate is not a prediction that rates will hold still. A fixed rate is an agreement that the loan will behave as though they had.

Read the definition from both sides at once. The borrower knows the amount leaving the account for the whole period. The lender has committed to a price it cannot revisit, and the lender's own cost of money is entirely free to move. The certainty on one side is manufactured out of exposure on the other. A settled number for one party is precisely what leaves the other one open. No version of this arrangement hands both of them the settled number.

The everyday version is a supplier who quotes a price for a year. A printer who tells a school that every notebook will cost the same figure until next March has handed the school a budget it can write down and rely on. The printer has simultaneously taken on whatever happens to the cost of paper. Nothing about the quote made paper cheaper or dearer. The quote moved the consequence of the paper price from the school to the printer, and the school paid for that move inside the quoted figure whether or not either of them called it that.

What is a floating-rate loan, taken on its own?

A floating-rate loan carries a rate assembled from two separate pieces. The first is a published reference. The reference sits outside the loan, moves on its own cycle for causes no party to the loan has any part in, and neither the lender nor the borrower can adjust it. The second is a spread, set at sanction and left where it was put. The loan's rate is the two of them added together, and the loan is recomputed from the current value of the first part at stated moments.

The two parts behave completely differently, and reading them as one number is where almost all confusion about this structure starts. A borrower who watches the total and sees it rise has watched two things at once: one that moved and one that did not. A borrower who has been told the spread is fixed and then sees the total change often concludes that they were misled, when what changed was the other half of the sum. Holding the two apart is not a fine distinction; it is the difference between understanding a loan and not.

Which loans must be benchmarked to what, and how often the rate must be recomputed, are not properties of the product. Both are requirements, both sit with the Reserve Bank of India, and both are revised. Both are read at rbi.org.in.

Set side by side, where exactly do the two part company?

Now that each has been defined on its own, the two can be run across the same five criteria in the same order. Read either column top to bottom and it stands up alone; read across and the allocation appears in the middle row and then explains the rest.

There is no row on which one structure is better, and that is a property of the comparison rather than a reticence in the writing. Every row says who is holding something. A row can only produce a winner once a view about what rates are going to do next is added, and at that moment the comparison is no longer between two structures. The comparison is then between one structure and a forecast. Nobody can supply that forecast, so the grid stops where a grid honestly stops.

Which side carries a rate move on each?

The allocation is the core of the matter. One event happens: rates move. Two contracts exist, and they put that event on opposite sides of the counter.

On a fixed-rate loan the borrower's payment does not change. The lender promised a price, and the price holds. The lender's own cost of money is under no such promise, so it moves with everything else, and the gap between what the lender agreed to earn and what it now pays for money is the lender's to absorb. On a floating-rate loan the borrower's obligation changes at the next reset. The lender is largely unaffected. The thing the lender is paid moved by roughly what the thing the lender pays moved by.

The promise runs both ways, and what a rate structure decides is not whether somebody carries a movement but which of the two parties does. Nothing in either contract makes the movement smaller. Nothing in either contract sends it somewhere outside the two of them. There are two parties, there is one movement, and the paperwork picks.

The picking cuts in both directions. Most explanations leave that half out. Rates fall as well as rise. On a fixed-rate loan a fall leaves the borrower paying a price agreed when money was dearer, and the lender is now funding that loan more cheaply than it expected. The side carrying the movement carries it whichever way it goes, and a structure that allocates a risk has allocated the gain from the same movement in the same breath. A reader who describes a fixed rate as protection has described half of it.

What does a movement actually cost, worked exactly?

Take a loan of Rs 51,00,000/- and work it as arithmetic rather than as anybody's loan. The amount is chosen to make the multiplication easy to follow, and nothing about a borrower enters the working. Notice what the working below needs and what it does not. The working needs the amount and the size of the movement. The working needs no rate level at all, because a change is what is being worked rather than an amount of interest.

If the reference moves up by 1.00 percentage pointThe unit a movement in a rate is measured in. A rate that goes from one level to a level one point higher has moved by 1.00 percentage point, whatever the two levels happen to be., the interest on Rs 51,00,000/- over a year changes by Rs 51,000/-. A movement of 0.25 of a point changes it by Rs 12,750/-. A movement of 2.00 points changes it by Rs 1,02,000/-. One multiplication produces all three, and the same multiplication runs unchanged in the other direction: 2.00 points down is Rs 1,02,000/- less over the same year on the same amount.

Now place each of those figures on the correct side. On the floating-rate loan the whole of the change lands on the borrower at the next reset, and it lands the same way when the reference moves down. On the fixed-rate loan the borrower's figure does not move at all, and the lender is now earning a rate it agreed to at sanction while paying whatever money costs it today. The rupees did not evaporate on the fixed loan; they crossed the counter.

Then a limit on all of it. A single year is kept for each institution and nothing else: no quarter, no prior year, no month by month path. A rate cycle runs longer than a year, and its effect shows up as a path rather than as a single level, so one year of figures cannot show what a rate move did to Suvarna Commercial Bank Limited or to Rukmini Finance Limited. The arithmetic supports one thing exactly, what a movement does to a single loan, and no claim at all about what happened over a cycle or what will.

A second absence sits behind the arithmetic. No borrower detail is recorded anywhere in it, no split of Suvarna Commercial Bank Limited's advances, no sector concentration and no restructured or written-off book. Every loan and balance worked here is therefore an arithmetic illustration and belongs to nobody. An invented borrower would sit here looking indistinguishable from a reported one, and a borrower invented in order to struggle would be a household written into hardship to decorate a lesson.

What does a reset actually change?

The reset is the mechanism nearly every reader has half right. When the reference moves, the interest owed over the remaining life of the loan changes. The change in the interest owed is arithmetic and it is not in dispute. The change is allowed to land in two places, and the two look nothing alike from the borrower's chair. The landing place is the part that gets missed.

The change can land on the instalmentThe single amount that leaves a borrower's account on each due date under the repayment schedule., leaving the number of payments where it was. Or it can land on the tenorHow long a loan still has to run, counted in payments or in months rather than in rupees., leaving the instalment where it was and changing how many of them there are. Both are recomputations of the same repayment scheduleThe table of due dates a loan runs on, setting out what is paid on each one and how many payments are still to come. from the same new reference. Neither is a concession and neither is a penalty. The two are arrangements of one arithmetic.

And here is the consequence that surprises people: a payment that has not changed is not evidence that nothing happened. If the change landed on the count rather than on the amount, the borrower's bank statement will look identical for months while the loan quietly runs longer than it did. The money is being paid either way. The difference shows up either in an amount the borrower can see or in a date the borrower has not been shown.

A lender's duty to tell a borrower at a reset, and the choices that must be offered when the change could land in either place, are requirements rather than arithmetic. Each sits with the Reserve Bank of India, each gets revised, and each is read at rbi.org.in.

Can a loan be switched, and what does repaying early cost?

Both questions come up constantly and both have the same shape of answer here. A loan can sometimes be moved from one structure to the other on stated terms. Repaying a loan before its date sometimes carries a charge and sometimes does not. Both of those are terms of the particular loan, sitting inside conditions set by the Reserve Bank of India, and both differ by the kind of loan and by the kind of borrower.

A switching term or an early repayment charge printed here would turn into a false statement, not just an old one, the day it was revised, and a reader carrying a false figure is worse off than a reader carrying none. The document that settles either question for any particular loan is that loan's own agreement, read alongside the requirement at rbi.org.in. Neither is obvious to find.

What does neither structure do?

Four things, and they are worth stating because each one is a belief a reader can arrive with. Neither structure makes the loan smaller. Neither changes the principalThe amount borrowed and still owed, kept separate from the interest charged on it.. Neither removes the movement in rates from the world. A contract between two parties has no reach over a published reference that neither of them sets.

And the fourth, the one that matters most: neither structure is a forecast. A fixed rate is not a statement that rates will rise, and a floating rate is not a statement that they will fall. Both are allocations of something nobody can see coming, agreed in advance precisely because nobody can see it coming. Reading a view into a contract that contains none is where people most often go wrong on this subject. The mistake is easy to make. The contract does become better or worse for the borrower afterwards, depending on what happens. Becoming better or worse afterwards is what carrying a movement means. The outcome is not evidence that anybody predicted anything.

Where does the same allocation show up on the deposit side?

Directly across the counter, and seeing both at once is what makes the whole idea click. A term depositMoney placed with a bank for an agreed period at an agreed rate. The rate is fixed for the holder for the whole of that period. fixes a rate for the holder and leaves the bank with a price it cannot revisit, which is precisely what a fixed-rate loan does with the two roles swapped. The same allocation appears on both sides of the same bank. A bank therefore thinks about the two together rather than one at a time.

A bank's cost of fundsWhat a lender itself pays for the money it lends on, worked out over its own named base. is not a footnote to this subject but the reason it matters. Suvarna Commercial Bank Limited holds deposits it has promised prices on and advances it has promised prices on, and a movement in rates reaches the two at different speeds depending on how each side is written. How far a movement travels on each side over a whole rate cycle takes more than a single year of figures to see.

Who decides how a rate is benchmarked and how often it resets?

Not the two parties by themselves. Seven separate requirements sit around a loan's rate, and not one of them is arithmetic: each is the Reserve Bank of India's to decide. Which benchmark a rate is tied to. How frequently a floating rate is recomputed. The disclosure a borrower hears at a reset, and which choices open up then. Any charge for clearing a loan ahead of its date, and which loans it reaches. The disclosure owed on the spread and the occasions it may shift. The terms governing a move between the two rate types. And fair practice, as between a lender and the person borrowing from it.

Each of the seven has an answer that changes, so the card below draws every one as a row with nothing in it. A row completed from recollection looks finished and is not, and the day a requirement shifts underneath it, the row stops being true rather than merely getting old. A blank row with its authority set inside it is a form to be filled from the source. The form keeps working long after the requirement has changed.