It was not too long ago when in one of my articles I had warned people from converting their floating rate housing loans to fixed rate.

While the recent moves by some of the leading banks/ housing finance companies substantiate that advice, there are other pitfalls ahead. Banks have now resorted to their old trick of taking advantage of your greed (and ignorance) in some other way. Read on...

A quick reminder

In 2003, when rates were low, banks deliberately kept the rates of interest on fixed housing loans slightly higher -- around 1 to 1.5 per cent higher -- than floating rate loans. This made housing loan seekers go for a floating rate loan, and today they are repenting for that (Floating rate home loans at 8-8.5 per cent then have climbed to around 11.5 per cent in 20007).

But now the cycle has changed. All but the RBI have announced rate cuts. That is not to say that RBI will go for a rate cut, but indications are that rates have topped and will either remain where they are or go down.

Some leading banks have already reduced their interest rates on housing loans.

What's the catch, now?

If rates on housing loans are to go down, so will rates on fixed deposits, FDs. Till recently, we were having FDs giving us annual returns of 10 per cent. Now as rates are expected to go down, interest rates on FDs will also reduce.

• Want a floating loan? Tread carefully

Think logically -- if you have two options, one to stay invested in an FD for 5 years with 9 per cent interest rate and another to stay invested in an FD for 1 year with 9 per cent interest rate, which one will you go for?

The second option seems more logical at this stage, as the returns are same but you get more liquidity, that is, your money remains locked in only for a year.

Let us tweak this a bit. Which of the above two options will you choose if you know interest rates were to go down over the next 1 year?

Now you will not like the second option, as after 1 year, you will have to reinvest the money you receive (as the FD matures after 1 year) at an interest rate lower than 9 per cent (as interest rates have come down)! This is known as reinvestment risk.

So, you are better off investing in FDs with long-term horizon in case you see interest rates coming down. Now, if this is beneficial for you, somebody has to be affected negatively -- namely the banks, where you deposit your money.

So the banks try to dissuade you from investing in FDs with longer term maturity, when they see rates going down. How will they achieve this?

• Buying a home? Choose your interest

By doing just what they did in case of housing loans when rates were low.

Banks keep the interest rate on short-term FDs higher than that on longer term FDs. When you see this, you will obviously fall for this and go for an FD with 1 year horizon.

So if you have two options, to stay invested in a 1 year FD with 9.5 per cent or to stay invested in a 5 year FD with 9 per cent; you would be tempted to go for the 1 year FD (just as people were tempted to go for the floating rate loan in 2003) but after 1 year when you receive the proceeds, and wish to reinvest, you may have to be content with a 7-7.5 per cent rate of interest.

So in a nutshell, you stand to lose, if you do not see through the curtain of that extra 0.5 per cent today.

There are some standard assumptions which I have made. It may also be the case that banks may be genuinely in need of short-term money, that's why the rate of short-term FDs are higher than long-term ones, or that you may be better off investing in a debt fund with longer-term bonds (higher maturity), or even that you may have the money only for one year, after which you would be wanting that for meeting some obligation.

• Home loans: 'Avoid a mix of fixed and floating' 

However, if you have to go in for a FD, and have 3-5 years horizon, it is prudent to think on these lines, as mentioned above. 

Whether rates will go down, when will they go down, by how much they will go down -- there is no point in guessing all that. But all that can be said is that right now all indicators point to a stable or a falling interest rate regime over the next 18 to 24 months; and if so be the case, why not pick a slightly longer term FD.

If you have made the mistake of going for a floating rate loan in 2003, do not repeat it this time around!

The author is a consulting personal finance trainer for various organisations. He can be reached at moneybee.finplan@rediffmail.com

Disclaimer: The article is for information purposes only. Please take a decision only after consulting your financial advisor. Money Bee Institute will not be responsible for investment decisions taken by readers based upon this or earlier articles. All figures are indicative and are used only as examples. Readers should not expect rates to move to levels mentioned, based upon this article.