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What Is a Fixed Interest Rate? - How Does It Work, Pros & Cons
Interest rate plays a significant role when choosing any financial product. You might have already heard about the two types of interest rates - fixed and variable. Both interest rate types have their share of pros and cons you should know in detail, but this article aims to discuss fixed interest rates. Knowing how fixed interest rates work and their advantages and disadvantages can help you make an informed decision when looking for funding options.
Understanding a Fixed Interest Rate
A fixed interest rate, if applied to a mortgage, loan, or credit card, means that the interest charged will remain static throughout the specified period. If you do not follow the conditions and terms of the loan, your rate may change.
How Does a Fixed Interest Rate Work?
Let's consider how a fixed interest rate works concerning a loan debt. For instance, if you take out a five-year loan of $40,000 at a fixed interest rate of 6%. Your monthly repayment amount would be $773.31. The monthly payment amount will remain the same throughout the five-year repayment term because the loan has a fixed interest rate of 6%. The interest rate paid for the loan will remain unchanged irrespective of changes in the finance market.
Types of Fixed-Rate Loans
There are many types of loans offering a fixed interest rate. These include:
A standard home loan, including both 30-year and 15-year mortgages, offers fixed interest rates.
2. Home Equity Loans
Lump-sum home equity loans usually have a fixed interest rate. Although home equity lines of credit (HELOCs) typically have a variable interest rate, it might be possible to convert your loan to a fixed interest rate.
3. Auto Loans
The majority of auto loans have a fixed interest rate.
4. Personal Loans
Personal loans offer both fixed and variable rates of interest. Some popular lenders provide personal installment loans with a fixed interest rate.
5. Student Loans
Federal student loans, issued after June 30, 2006, offer fixed interest rates. Before mid-2006, private student loans might have either a fixed or variable interest rate.
Pros and Cons of Fixed Interest Rates
Now that you have learned what a fixed rate is and how it works, it's time to consider its advantages and disadvantages.
Pros Of A Fixed Interest Rate
- A fixed-rate loan enables you to know your monthly loan repayment amount.
- A fixed interest rate makes it easy to draw a comparison among various financial products.
- Since the interest rate is predetermined, there is zero risk of payment shock down the road from increased interest rates.
Cons Of A Fixed Interest Rate
- Loans with a fixed interest rate might be more expensive than loan options offering a variable interest rate.
- If the interest rates fall, you will need to refinance or live with your higher rate.
- If you're looking for short-term lending options, they may not compare well against adjustable-rate loans.
How to Calculate Fixed Interest Rate?
To calculate the interest payable on a particular loan with a fixed interest rate, you need to know the loan amount, the loan repayment period, and the interest rate. Here's an example to understand how the fixed interest rate works.
Example Of Fixed Interest Rate
If you take out a typical loan of $35,000 for debt consolidation, the loan term is four years, and the interest rate on the loan amount is at 6%. Your monthly payable amount would be $821.98, and the total interest you would have to pay over the four years would be $4,454.85. Your monthly payment amount will remain $821.98, provided you do not increase your monthly payment amount to repay your loan quickly.
Fixed Vs. Variable Interest Rates
Financial products offering a fixed interest rate are popular among people with lower-risk appetites. A fixed interest rate will allow consistent monthly payments without any unexpected changes.
On the other hand, a variable interest rate, as the name suggests, is a type of interest rate that changes over time in response to market interest rates or prime interest rates. In the context of interest rates, a variable means that the interest rate either increases or decreases.
Financial products offering variable interest rates are ideal for people willing to take risks. The borrower may be rewarded with lower payments or have a higher payment on their loan. However, the fluctuating interest rate makes it difficult for individuals to plan their finances.
You should know that a borrower's interest rate concerning either type of loan depends heavily on your credit scores, loan product, and the lender.
The interest rate offered on any financial product heavily impacts your financial decisions. Both fixed and variable interest rates have their share of advantages and disadvantages. Choosing a fixed or variable interest rate depends on your financial situation and risk appetite. Fixed interest rate financial products are mostly preferred because borrowers can accurately predict future costs and monthly payments.
Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.
With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.
When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.