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What is a fixed interest rate and how does it work?
Finding stability in a world full of financial uncertainty can be hard and even if you make all the right choices, you may find yourself bogged down by setbacks. Loans with fixed interest rates can be your rescuer. Read on to understand everything about interest rates, the advantages and disadvantages of fixed interest rates and how you can calculate the interest on your loans.
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What is a fixed interest rate?
Interest rates can be broadly categorized into two types—fixed interest rate and variable interest rate.¹ As the name suggests, fixed interest rates are fixed and don’t change for a set period or sometimes, the entire duration of the loan.
Borrowers may prefer to lock in a fixed interest rate to avoid risks associated with the constant changes in the market. Once the fixed interest period is over, your loan may shift to a variable rate or you may be able to lock in another fixed interest rate.
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How does a fixed interest rate work?
When taking out a loan, you can either go for a fixed or variable personal loan. If you take out a fixed-interest loan, you’ll only pay the fixed amount of interest for a set period of time. Even if the Australian market fluctuates or there are adverse changes in the economy, the interest rate charged on your loan will remain constant.
You can take out loans like car loans, student loans, home equity loans, etc. with fixed interest rates. Fixed loans provide stability and predictability of knowing exactly how much you need to pay each month towards your loan. With variable-interest loans, the amount payable on the loan varies depending on the changes in the market interest rate, which can increase or decrease unexpectedly.
Generally, the rate of interest charged in fixed loans is higher than in variable loans, but fixed loans can help you avoid the added risk of unpredictability involved in variable interest loans. Fixed interest rates are especially beneficial if you lock in a rate when the market rate is relatively low but is about to increase.
Fixed interest rate loan example
Let’s take a closer look at how fixed interest rate loans work. Imagine you’ve taken out a $50,000 loan for 1 year at a 5% fixed interest rate. The estimated monthly payment would be $4,280 and the total interest would be $1,364. The 5% fixed rate means you’ll pay $50,000 (principal amount) + $1,364 (5% interest on $50,000 compounded monthly) = $51,364 to the lender.
Now, say you’ve taken a mortgage of $100,000 for 30 years at a 3.5% interest. In this case, the estimated monthly payment will be $449 and the total interest comes out to be $61,656.² The interest paid on the principal amount is the profit made by the lender.
These values will change if you repay the loan earlier by increasing your monthly payments.
How to calculate fixed interest rate
Let’s simplify how you can calculate your fixed-interest rates, monthly payments and the total amount payable for your loans. Here’s an easy formula you can use:
(Interest Rate/Number of Payments) * Loan Principal = Interest
For example, if you borrow $50,000 to be repaid over 3 years at a 5% interest rate, you’d have to make 12 payments every year. So your monthly interest will be:
(0.5/12) * 50,000 = $208
So, your total monthly payment including both the principal and interest will be $1499.
However, if you’ve already made some payments and want to figure out how much you still need to repay, you can use this formula:
Principal – (Repayment – Interest) = New Balance
For example, if you’ve paid back $5,000, the calculation would be
$50,000 – ($5,000 – 5% of 50,000) = $45,250.
The interest is charged and adjusted according to the balance.³
Why do banks offer fixed rate loans?
Banks offer fixed interest rates because these rates attract customers who are reluctant to take risks. Borrowers choose fixed rates since they provide stability and predictability, and assure the borrowers that repayment amounts will not change with time. Further, it also helps the banks manage their risks effectively and diversify their lending portfolios.
Fixed interest rate costs
When you take out loans at fixed rates, you make sure your repayments won’t be swayed by market fluctuations. But this predictability and ease comes at a cost. Here are a few costs you may bear to lock in a fixed interest rate for your loan:
- Additional Fees: In case of fixed loans, lenders may charge additional establishment or service fees to process your loan application. This could be a percentage of your loan amount or a fixed amount, based on the lender’s loan terms.
- Penalties: If you repay the loan earlier, some lenders may impose a penalty. This penalty can be a percentage of the remaining amount or the monthly interest, as predetermined in the loan agreement. Credit24 doesn’t charge any extra fee for early repayments.
- Higher Rates: Fixed interest rates offered by the lenders can differ from the prevailing market rate. Lenders generally charge higher interest rates for longer fixed-rate periods.⁴
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Advantages and disadvantages of fixed interest rates
Depending on your needs, fixed interest rates can have their advantages and disadvantages.
Pros of fixed interest rates are:
- Predictability: Knowing exactly how much you’ll pay each month makes budgeting easier and predictable.
- Protection against increasing market rates: Fixing your rate can shield you from potential changes in the market rates.
- Peace of mind: Locking in your interest rates offers peace of mind since you don’t need to worry about changes impacting your finances.
- Stability: It provides protection from economic uncertainty and crisis.
Cons of fixed interest rates:
- Higher initial rates: Generally, fixed interest rates are higher than initial variable rates.
Less flexibility: Since fixed-rate loans are generally less flexible, you’ll not be able to take advantage of any decrease in market rates unless you refinance.⁵
So, are fixed interest rates good or bad?
Fixed interest rates can be both good and bad depending on your priorities. If you prefer stability and predictability, fixed interest rates could be a good option. However, it may not be the best idea if interest rates are expected to decline in the future and you’re willing to bear the risk. So, it’s important to analyze your options, financial goals and risk tolerance before choosing the interest rate for your loans.
Difference between fixed and variable loan
Fixed or variable personal loans, which are better for you? Let’s understand the difference between fixed and variable interest rates to make your decision easier.
- With fixed loans, the interest rate remains the same throughout a set period of the loan term whereas with variable loans, the interest rate changes over time as per the change in the market.
- Fixed loans provide stability and predictability and are less risky whereas variable loans involve higher risk.
- Fixed loans offer less flexibility as compared to variable loans.
- It’s easier to plan your budget with fixed rates than variable rates since you have to pay the same amount every month. With a variable loan, your monthly payments can change every month.
How to get a fixed term personal loan with Credit24
With Credit24, you can apply for small, medium and large personal loans between $500 and $10,000. Small loans between $500 and $2000 don’t require any interest. For medium and large loans, the fixed interest rate ranges from 24% to 48% p.a. Here are a few reasons why Credit24 is a good choice for online fixed-interest loans:
- 10 minutes easy and 100% online application process
- Loans available from $500 to $10,000
- Same-day loan pay-out, if application is approved
- Fixed and transparent repayments scheduled and shared upfront
- Flexible loan repayment options
If you want to be considered for a fixed-term personal loan with Credit24, you just need to fill out a 10-minute easy application by providing us with some of your details and fulfilling our basic eligibility criteria.
We’ll only ask for:
- your mobile number,
- your email address,
- your ID (driver’s license details, your passport number or Medicare Card), and
- your last three months of bank statements collected via Illion’s secure bank data portal.
To be eligible for a Credit24 loan, you must:
- be a Permanent Resident or an Australian Citizen,
- be 18 years of age or over,
- be employed and receive the salary in your bank account,
- have a consistent monthly income of at least $1,000, and
- have a reasonable credit and financial history.
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Disclaimer:
IPF Digital Australia Pty Ltd, trading as Credit24, ABN 59 130 894 405. Australian Credit Licence 422839. The information in this article is of general nature and does not take into consideration your objectives, financial situation or needs. Lending criteria, fees and charges apply. For more information about our products, eligibility criteria and terms and conditions, please visit www.credit24.com.au.
Sources:
- Consumer Financial Protection Bureau: Understand the different kinds of loans available
- Investopedia: Fixed Interest Rate: Definition, Pros and Cons, vs. Variable Rate
- InfoChoice: Principal and Interest Calculator
- Parliament of Australia: Would 30-year fixed-rate mortgages be viable in Australia?
- Forbes Advisor: Fixed Rate Home Loans Explained