# Fixed Interest Rate

A static interest rate that is charged on a liability

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## What is a Fixed Interest Rate?

A fixed interest rate refers to a static interest rate that is charged on a liability – such as a mortgage, credit card, loan, or corporate bond. A fixed interest rate may apply to a liability’s entire term or over a partial period of its term.

### 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.

### Understanding Fixed Interest Rates

An interest rate is a rate charged for borrowed money and is typically expressed as a per annum percentage. A fixed interest rate is popular with borrowers who want exact certainty on their repayment amounts.

For example, there is exact certainty in determining the monthly repayments of a \$50,000 mortgage with a term of 10 years at a fixed interest rate of 5% versus determining the monthly repayments of a \$50,000 mortgage with a term of 10 years at a variable interest rate of prime + 2%, with the lower certainty in the variable interest rate stemming from the prime rate.

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. Variable interest rates are typically tied to the overnight rate, and as the overnight rate increases, the variable interest rate increases, resulting in higher repayment amounts.

• 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.

• 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.

### Practical Example

Question 1: Tim is presented with two loan options:

Tim believes that the prime rate will be the following over the next three years:

Given the information provided, which loan option would result in a lower total payment?

Answer: Loan 1 would result in a lower total payment. The calculation for each loan is provided below.

Loan 1: The yearly interest payments are calculated as \$100,000 x 5% = \$5,000. The yearly payment amount is unchanged each year, as Loan 1 features a fixed interest rate. As such, the total payment is calculated as \$5,000 (interest in Year 1) + \$5,000 (interest in Year 2) + \$105,000 (interest + principal in Year 3) = \$115,000.

Loan 2: As Loan 2 features a variable interest rate with a changing prime rate each year, the yearly interest payments differ each year. The total payment is calculated as \$4,000 (\$100,000 x [2% + 2%] interest in year 1) + \$6,000 (\$100,000 x [4% + 2%] interest in year 2) + \$108,000 (\$100,000 x [4% + 2%] interest + principal in year 3) = \$118,000.

Question 2: As a financial advisor to Tim, provide a comment regarding the certainty of interest payments under Loan 1 versus Loan 2.

Answer: Loan 1 features a fixed interest rate and, as a result, the yearly interest payments on the loan are certain. On the other hand, Loan 2 features a variable interest rate, which causes uncertainty in the yearly interest payment amounts.

### Calculating Repayment Amounts for Fixed-Rate Mortgages

The Government of Canada’s mortgage calculator can help potential borrowers determine mortgage payment amounts, given a fixed interest rate.

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