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.
- 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 to borrowers that 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.
Advantages and Disadvantages of a Fixed Interest Rate
- 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.
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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