What is a Fixed Interest Rate
A fixed interest rate is an interest rate on a liability, such as a loan or mortgage, that remains the same either for the entire term of the loan or for part of the term. A fixed interest rate is attractive to borrowers who do not want their interest rates to rise over the term of their loans, increasing their interest expenses.
BREAKING DOWN Fixed Interest Rate
A fixed interest rate avoids the interest rate risk that comes with a floating or variable interest rate, in which the interest rate payable on a debt obligation varies depending on a benchmark interest rate or index.
Homebuyers in particular should be aware of the pros and cons of loans with fixed rates. While shopping for a mortgage or another loan, consumers should compare fixed-rate loans to products with variable or floating interest rates.
Advantages of Fixed Interest Rates
Because the interest rates on fixed-rate loans stay the same, the borrowers' payments also stay the same. This makes it easier to budget for the future. To illustrate, imagine someone buys a $375,000 home with 20% down, and he takes out a $300,000 mortgage with a 4% fixed interest rate with a 30-year term. Every month for the life of the loan, his payments are $1,432. The homeowner may face varying monthly bills as his property taxes change or his homeowners insurance premiums adjust, but his mortgage payment remains the same.
Disadvantage of Fixed Interest Rates
Loans with adjustable or variable rates usually offer lower introductory rates than fixed-rate loans, making these loans more appealing than fixed-rate loans, especially when interest rates are high. As a result, borrowers are more likely to opt for fixed interest rates during periods of low interest rates; the opportunity cost, if interest rates go lower, is still much less than during periods of high interest rates.
Difference Between Fixed and Variable Interest Rates
While fixed interest rates stay fixed or set, variable interest rates vary or adjust. For example, if a borrower takes out an adjustable rate mortgage (ARM), he typically receives an introductory rate for a set period of time, often for one, three or five years. After that point, the rate adjusts on a periodic basis, as outlined in the mortgage agreement.
To illustrate, imagine the bank gives the borrower a 3.5% introductory rate on a $300,000 30-year mortgage with a 5/1 ARM. During the first five years of the loan his monthly payments are $1,347. However, when the rate adjusts, it increases or decreases based on the interest rate set by the Federal Reserve or another benchmark index. If the rate adjusts to 6%, for example, the borrower's payments increase to $1,799. In contrast, if the rate falls to 3%, the monthly payments fall to $1,265. Conversely, if the 3.5% rate is fixed, the borrower faces the exact same $1,347 payment every month for 30 years.