What is Fixed Interest Rate and How Does It Work?

What Is a Fixed Interest Rate?

A fixed interest rate is an unchanging rate charged on a liability, such as a loan or a mortgage. It might apply during the entire term of the loan or for just part of the term, but it remains the same throughout a set period. Mortgages can have multiple interest-rate options, including one that combines a fixed rate for some portion of the term and an adjustable rate for the balance. These are referred to as “hybrids.”

Summary

  • A fixed interest rate is a static interest rate that is charged on a liability.
  • A fixed interest rate is popular to borrowers that want exact certainty on their repayment amounts.
  • In a rising overnight rate environment, consumers with mortgages tend to prefer locking into a fixed interest rate over opting for a variable interest rate.

How does a fixed interest rate work?

With fixed-rate financing, your loan’s interest rate won’t fluctuate over the life of the loan — meaning you’ll know exactly how much each monthly payment will be, as well as how much it will cost you overall to pay off the loan based on that rate.

On the other hand, a variable interest rate can fluctuate, lowering or raising the amount on your monthly payments accordingly. With a variable rate, you have no way of knowing when you take out the loan whether your payments will go up, down, or remain the same over the life of the loan.

You won’t always have the option of choosing between fixed and variable. For example, federal student loans borrowed on or after July 1, 2006, have fixed interest rates. But private student loans may have either a fixed interest rate or a variable rate, the latter of which could change your payment amounts over time.

Fixed Interest Rate

Advantages and Disadvantages of a Fixed Interest Rate

Key advantages:

  • Certainty in repayment amounts: The borrower has full transparency on the required payment amounts, as it is unchanging.
  • Protection from sudden increases in the overnight rate: The borrower does not need to worry about increases in the overnight rate and its impact on its fixed interest rate.
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Key disadvantages:

  • Potentially higher repayment amounts: If the overnight rate is low, a variable interest rate tends to be lower than a fixed interest rate. Furthermore, it is common for lenders to offer a low variable interest rate in the first few years of repayment.
  • No upside from sudden decreases in the overnight rate: Although a fixed interest rate is exempt from the adverse impact of overnight rate increases on a variable interest rate, it is also exempt from the beneficial impact of overnight rate decreases on a variable interest rate.

Example of fixed rate

Taylor is ready to become a homeowner. He decides that he wants a 30-year fixed-rate mortgage because he plans to stay in the home for many years and he wants a consistent monthly payment — not one that could fluctuate with the market.

Taylor borrows $200,000 at a fixed rate of 4 percent, resulting in a monthly payment of $955 per month. The day after he closes on his loan, mortgage rates shoot up. But Taylor isn’t worried, because his mortgage rate is fixed for the life of the loan.

Is a fixed interest rate right for you?

Before you decide whether to go with a variable or fixed interest rate, let’s look at how each rate can affect your loan.

Let’s say you take out a 60-month $20,000 loan on a new car at a fixed interest rate of 3.99%, with monthly payments of about $368. Your total repayment amount with interest would be $22,094.

But if the loan has a variable rate, and the interest rate goes up, your payments and the total repayment amount could increase. Conversely, if the interest rate happens to drop, you may save money overall.

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Choosing between a fixed or variable interest rate may come down to your comfort level with risk. While you may be able to find a variable-rate loan with lower initial interest rates than a fixed-rate option, you run the risk of the variable rate increasing before you’ve paid off your loan. If you like the security of a loan payment that won’t fluctuate according to the prime rate or other index rates, you may prefer a fixed interest rate.

Fixed vs. Variable Interest Rates

Variable interest rates on adjustable-rate mortgages (ARMs) change periodically. A borrower typically receives an introductory rate for a set period of time—often for one, three, or five years. The rate adjusts on a periodic basis after that point. Such adjustments don’t occur with a fixed-rate loan that’s not designated as a hybrid.

In our example, a bank gives a borrower a 3.5% introductory rate on a $300,000, 30-year mortgage with a 5/1 hybrid ARM. Their monthly payments are $1,347 during the first five years of the loan, but those payments will increase or decrease when the rate adjusts based on the interest rate set by the Federal Reserve or another benchmark index.

If the rate adjusts to 6%, the borrower’s monthly payment would increase by $452 to $1,799, which might be hard to manage. But the monthly payments would fall to $1,265 if the rate dropped to 3%.

If, on the other hand, the 3.5% rate were fixed, the borrower would face the same $1,347 payment every month for 30 years. The monthly bills might vary as property taxes change or the homeowner’s insurance premiums adjust, but the mortgage payment remains the same.