Fixed Rate

Fixed Rate
A fixed rate is an interest rate on a loan that will remain the same over the course of the loan, so the amount the borrower pays in interest never changes.

How do Fixed-Rate loans work?

With a fixed-rate loan, the borrower’s interest rate is established before the loan is signed. The borrower agrees to pay that rate over the life of the loan, or for a predetermined period of time.

The alternative to fixed-rate loans are variable-rate loans. With variable-rate loans, the interest that the borrower pays fluctuates. The rate is tied to market conditions, and it rises and falls with the market.

With a fixed-rate loan, the borrower will pay the same regardless of market conditions. If the market turns in one direction, the borrower’s interest rate may be effectively lower than prevailing interest rates. If the market turns in the other direction, the borrower’s rate may be effectively higher than prevailing rates.

Typically, short-term interest rates rise when the economy is growing and fall when the economy is contracting.1

Is a Fixed-Rate loan good?

Fixed-rate loans offer several major benefits.

One advantage of fixed-rate loans is that borrowers know exactly how much they’ll be paying for their loan. They know the total cost and how much they’ll owe for each payment. This doesn’t change, so borrowers can plan better and create a budget that will allow them to make their payments on time.2

Another advantage of fixed-rate loans is that borrowers are protected if market conditions change and interest rates rise. The borrower will always pay the same amount, which may be significantly less than prevailing rates.

Is a Fixed-Rate loan bad?

While fixed-rate loans offer benefits, they also come with drawbacks. Compared to a variable-rate loan, the initial interest rate for fixed-rate loans is usually higher.3 However, the primary disadvantage with fixed-rate loans is that borrowers can end up paying a higher rate than the market dictates if economic conditions change and interest rates drop. If this happens, the borrower with a fixed-rate loan is locked into the original interest rate, even though prevailing interest rates might be much lower.

Is a Fixed-Rate loan better than a variable-rate loan?

A fixed-rate loan is neither better nor worse than a variable-rate loan—it depends on the needs of the borrower, as well as factors (like market conditions) that are outside the borrower’s control.

One rule of thumb is that potential borrowers might want to choose a fixed-rate loan if it looks like interest rates are about to rise. If interest rates are about to fall, a variable-rate loan might be a better option, as the borrower’s rate will decrease with the prevailing interest rates. However, there’s more to consider when comparing fixed- and variable-rate loans.

The basic difference between fixed and variable rates can be understood as a matter of risk and reward. Variable-rate loans contain more risk, as interest rates may increase with the changing market. However, with the risk that a borrower will pay more comes the potential for reward. If the market goes in the opposite direction and interest rates decrease, a borrower with a variable-rate loan will pay less than the borrower with a fixed-rate loan.

A fixed-rate loan comes with no risk of higher interest rates, but it also comes with no chance for reward if the interest rates drop. Fixed rates ensure that the borrower will pay no more than the original rate, which makes budgeting easier and provides peace of mind. For some borrowers, these benefits may outweigh the potential rewards that come with a variable-rate loan.

What kind of loans have Fixed Rates?

Many types of loans offer fixed rates. There are long-term loans like home mortgages and student loans, as well as short-term personal loans and installment loans, among others.

References

  1. Strohm, Mitch. (2016, October 18). How interest rates are determined. Retrieved from http://www.bankrate.com/finance/cd/how-interest-rates-are-determined.aspx
  2. Investopedia. Fixed Interest Rate. Retrieved from http://www.investopedia.com/terms/f/fixedinterestrate.asp
  3. Anderson, Tom. (2016, March 22). When a variable-rate loan is right for you. Retrieved from http://www.forbes.com/sites/tomanderson/2016/03/22/when-a-variable-rate-loan-is-right-for-you/#5ed631f93352

Related Terms

Interest Rates
Finance Charges