Fixed Interest Rate

A static interest rate that is charged onto a liability

What is a Fixed Interest Rate?

A fixed interest rate refers to a static interest rate that is charged onto 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.

 

Fixed Interest Rate

 

Summary

  • A fixed interest rate is a static interest rate that is charged onto 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.

 

Fixed Interest Rate vs Variable 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.

 

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.

 

Practical Example

Question 1: Tim is presented with two loan options:

 

Sample Table

 

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

 

Prime Rate


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.

 

Related Readings

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Debt Schedule
  • Effective Interest Method
  • Prime Rate
  • Variable-Rate Mortgage