Fixed Interest Rate

A rate that does not change over time and is charged on debt obligations such as loans and mortgages

When people don't have enough money to buy something, they usually try to borrow money from lending institutions, such as banks, insurance companies, savings associations, credit unions, and others. 

Fixed interest rate

Lending institutions provide customers with two types of loans: fixed and variable rate loans. This is where the borrower needs to assess and compare the two rates and decide which one is more suitable. 

Note that it can be frustrating to choose between the two rates, and it will all depend on the borrower's situation and preferences. 

Meanwhile, the fixed rate is one of the most widely used interest payment methods, especially for mortgage borrowers. 

A fixed interest rate does not change over time and is charged on liabilities such as loans and mortgages. It may apply for the entire term of the loan or a specific period of the loan term.

Fixed rates are generally higher than variable rates when the interest rate is historically low, and that is because the interest rate can increase in the future. In contrast, when interest rates are historically high, the interest rates are more likely to fall throughout the loan term.

What is a fixed interest rate? 

It is a rate charged on money borrowed that does not change throughout the loan duration and is favorable to borrowers who want to pay a stable interest rate over the loan term. 

There are many types of fixed-interest rate loans. These include:

Borrowers will know in advance of the future interest payments that will occur. Therefore, the fixed interest rate is safer than the variable interest rate. 

The latter is also known as the floating rate. Unlike the fixed rate, it is a rate that changes throughout the loan. 

The rate is determined based on an interest rate index, such as the international standard rate LIBOR, and a spread selected based on the borrower's creditworthiness. 

For instance, it is easier to determine the monthly repayment of a 10-year loan that offers a 3% fixed interest rate when compared to borrowing a loan with a variable interest rate.

How to calculate

It is usually easy to calculate and very straightforward. Moreover, it can be calculated with different time durations, such as interest per month and year.

Calculation

The annual interest formula is:

Interest Rate x Principal = Interest Payment per year

For example:

Interest = 4%

Principal borrowed = $50000

Interest Payment/ Year = 4% x $60000 = $2400/ year

Monthly Interest Formula:

(Interest Rate/ number of payments) x Principal = Interest Payment per month

For example:

Interest = 4%

Principal borrowed = $50000

Number of payments = 12 months

Interest Payment/ month = (4% / 12) x $60000 = $200/ month

The difference between fixed and variable interest rate

The fixed interest rate has a stable payment for a certain period, while the variable interest rate might go up or down over time depending on a benchmark or index, like the federal funds rate.

Differences

For instance, we consider the following example:

Example
Fixed interest rate loan (Loan1)Variable interest rate loan (Loan2)
Principal amount = $10000Principal amount = $10000
Loan term = 5 yearsLoan term = 5 years
Interest rate = 3% / year Interest rate = prime rate +1% / year 

To compute Loan 1, we multiply the principal amount by the interest rate: 

Principal AMount = $10000 x 3% = $300

As of each year until the end of the loan repayment, $300 is the annual payment rate. Accordingly, the total amount to be paid is:

 Total Amount = ($10000 x 5 years x 3%) + principal amount = $1500 + $10000 = $11500

To compute Loan 2: the prime rate will change over time. If we consider a 1.5% prime rate for the first three years, then a changing prime rate to 2% for the remaining two years, the total amount to be paid at the end of the loan would be: 

Interest payment for the first three years (years 1, 2, and 3):

= Principal amount x Variable Interest Rate x Loan term

= $10000 x (Prime rate + 1%) x 3 years

= $10000 x (1.5% + 1%) x 3 years

= $10000 x (2.5%) x 3 years

= $750

Interest payment for the remaining two years (years 4 and 5):

= Principal amount x Variable Interest Rate x Loan term 

= $10000 x (Prime rate + 1%) x 2 years

= $10000 x (2% + 1%) x 2 years

= $10000 x (3%) x 2 years

= $600

Total Interest payment:

= Interest payment for year(1-2-3) + Interest payment for year(4-5)

= $750 + 600

= $1350 

The total amount to be paid:

= Principal amount + Total Interest payment

= $10000 + $1350

= $11350

In the above example, Loan 1 is higher than Loan 2 because the fixed interest rate is higher in the first three years than the variable interest rate. Therefore, the borrower would only benefit if the variable interest rate moved more aggressively to the upside.

Advantages and disadvantages

When borrowing money, choosing a fixed rate for your loan can be a good choice, especially if the borrower expects the interest rate in the market to exceed the fixed rate. Yet, in the case of a drop in the interest rate, the fixed-rate loan won't be a good choice after all.

Pros and cons

When choosing between the two rates, the decision should be taken wisely with a proper examination of the current economic situation and what could be potential central bank measures.

Pros

  • Eliminate uncertainty: The rate will stay as-is from the beginning until the end of the loan term.
  • Stability: All interest payments are stable and do not change at any time throughout the loan term.
  • Reduced risk: Beneficial for borrowers who have a stable flow of income. 

Cons 

  • Higher interest rate payment: Generally, fixed interest rates tend to be slightly higher than variable interest rates, which would be the cost of certainty.
  • Unprofitable: A fixed interest rate loan would be inopportune if the floating rate remains stable or decreases in basis points.
  • It can be a waste of money: A borrower with a fixed interest rate loan won't benefit from a decline in the interest rate and will keep paying the same rate agreed upon at the beginning of the loan agreement. Alternatively, a loan with a variable rate will always be in tune with the actual interest rate in the market.

Why choose?

The rate will remain the same throughout the loan term, which can be helpful for the borrower in calculating future interest payments. In addition, businesses prefer a fixed interest rate to better forecast their future expenses.

Note that a fixed rate gives certainty. This explains why customers prefer using it to borrow loans or mortgages. They'd rather pay a little more in interest rate to have certainty than take the risk that arises with the variable rate. 

Reasons to choose

To illustrate, assume that you want to buy a house:

You will have to take out a mortgage before proceeding if the banker told you that they offer 30-year fixed-interest mortgages. It is more likely that the borrower will decide to take the fixed-rate mortgage, knowing that over 30 years, taking out a variable-rate mortgage can be risky.

For people who set a budget to pay a mortgage at a stable amount, a fixed-rate mortgage (FRM) is the way to go. However, if the borrower prefers to pay the mortgage depending on their economic well-being, an adjustable-rate mortgage (ARM) is the better choice. 

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Researched and authored by Elie Zakhour | LinkedIn

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