Fixed Interest Rate Definition Calculation Vs Floating Rate

Fixed Interest Rate Definition

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A liability may hold a fixed rate for the entire period or throughout a limited duration. It is relatively higher (1%-2%) than a floating interest rate and provides a steady repayment amount. As per the creditor’s terms, the fixed rate on a long-tenure mortgage converts to a floating rate over time.

Key Takeaways

Fixed interest rate is a predetermined rate charged on the liability with unalterable monthly installment plans and debt refund period. It shields investors from any market interest rate fluctuations and is mostly employed during periods of low-interest rates. It contrasts with a floating (variable) interest rate in terms of loan duration, EMI, the impact of market conditions, and risk potential. The fixed interest rate benefits borrowers looking for a safe financing option with pre-fixed EMI over the debt tenure.

Fixed Interest Rate Explained

An interest rate is the cost of borrowing funds. It is a percentage of the total debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more a borrower must pay periodically to the lender. Such a rate may be fixed or variable. A fixed rate denotes an unvarying charge (in annual percent) imposed by the lender on the cash lent.

Unlike the variable rate, which fluctuates with a rate index, the fixed rate remains stable. This gives the borrower the advantage of knowing the exact periodical payments to be made during the loan Loan A loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read moretenure. This knowledge reduces uncertainty and increases the possibility of a timely mortgage settlement.

Interest rates charged by a lender depend on various economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more like monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more, inflationInflationThe rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.read more, etc. Also, borrowers are charged rates based on their individual income and credit scores. Besides, each lender accounts for its operating costs and risk toleranceRisk ToleranceRisk tolerance is the investors’ potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor’s age, income, investment objective, responsibilities and financial condition.read more before settling on the applicable rates.

How to Calculate Fixed Interest Rate?

Suppose Carina has to reimburse a $90,000 home loan to be refunded within ten years at a fixed rate of 6%. Now, she must know three elements to calculate the interest repayment, i.e., loan amount, interest rate, and loan repayment term.

Here,

Loan amount = $90,000Fixed interest rate for home loan (annual) = 6%Loan period = 10 years

Hence,

Annual interest payment = $90,000 x 6% = $5400Interest payment for 10 years = $5400 x 10 = $54,000

So, Carina’s total interest to be paid within 10 years is $54,000.

The total amount to be repaid = Loan amount + Interest

=$90,000 + $54000 = $144,000

Benefits and Drawbacks

The benefits and drawbacks of opting for a fixed rate against a variable rate may depend on the financial market Financial Market The term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read moreconditions.

Pros

Security – A fixed rate safeguards the debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion.
read more from an unexpected growth in equated monthly installment (EMI) resulting from an increase in the market rate of interest. Thus, a fixed rate offers immunity from interest rate risks and protects the borrower over the term of the debt.Predictability – The borrower is fully aware of how much to shell out each month and how long the advance paymentsAdvance PaymentsAdvance payment is made by a buyer to the seller before the actual scheduled time of receiving the goods and services. It protects the seller from the risk of non-payment. Additionally, it helps sellers financially in the production of the goods or rendering of services.read more are required. This removes any ambiguity or uncertainty over payments. Therefore, fixed rates ensure safety and certainty.Easy calculation – Since there are no variable elements in calculating EMI, measuring and tracking the payments are relatively uncomplicated. Hence, fixed rates ensure appropriate capital management with a trouble-free remittance. Planning and budgeting – With the predictability of cash outflows, borrowers can plan their short-term as well as long-term finances with ease. Fixed rates suit meticulous budget planners with an aversion to any major EMI changes.

Cons

Potential loss due to lower interest rates – Market rates of interest may at times see dips that benefit floating rate loanees substantially. However, fixed-rate borrowers have to continue paying their pre-fixed EMI without any change. Higher re-compensation amount – Since the loanee does not benefit from the reduction in prices in the case of fixed rates, the loan amount repaid usually turns out to be more than variable rates. Thus, a fixed rate implicates unaltered yearly debt compensation. Penalty – Debtors may be penalized for partial or complete prepayment of fixed interest debts, subject to the money lending organization. Common for short-term commercial loansCommercial LoansCommercial loans are short-term loans used to raise a company’s working capital and meet heavy expenses and operational costs. It is a kind of financing often used by small companies that cannot afford to raise money from equity markets and bonds. Banks and well-established financial institutions often provide commercial loans against the debtor’s financial statements and credit score.read more, the prepayment penaltyPrepayment PenaltyThe prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment penalty.read more charge remains inconsistent.

Fixed vs Floating Interest Rate

Ideal Choice

A fixed rate is ideal for borrowers looking for a specified debt obligation without any risk of fluctuating payments on account of varying market rates of interest. However, before making a choice regarding interest rates, borrowers must consider the unpredictable financial climate or trend.

Borrowers witnessing stable or potentially rising market rates must choose a fixed rate. On the other hand, if they suspect a downward trend in the future, it is ideal to opt for variable interest ratesVariable Interest RatesVariable interest rate refers to a mortgage or loan interest rate that fluctuates with the market conditions. The interest levied on variable loans depends on the reference or benchmark rate—an index. read more.

Alternately, loanees may switch from fixed to floating rates and vice-versa on applicable charges. However, they must appraise their financial status and requirements before making the final decision. Reset is a key phrase in this context. It infers the shift from the fixed rate on loans to a floating rate with time, subject to moneylenders’ terms.

Recently, the US has disclosed a significant rise in the average contract interest rate for the 30-year fixed interest rate home loan. It rose from 3.83% to 4.05% for loan balances of a maximum of $647,200. As the rates increase, there is a fall in the mortgage demand. However, the average loan size has set a record at $453,000.

Furthermore, the growth in the mortgage rate is attributable to the latest increase in treasury earnings. The treasury rates have soared because of constant inflationary pressures and enhanced market expectancy from the Federal Reserve to step up its efforts to reduce inflation.