Loans are essential tools for helping consumers like you purchase large items you would otherwise have to save years to buy on your own. This includes automobiles, large appliances, homes, and other things. However, you need to understand a few key terms and phrases before you take out a loan so that you do not accept loan terms that are unfavorable to you. One of those terms is "fixed-rate loans." The better you understand what a fixed-rate loan is and what it means, the wiser choices you can make about borrowing today and in the future.
What is a Fixed Rate Loan?
Lenders are incentivized to loan money to consumers because they can charge interest rates on the money they provide. This interest rate represents their return on investment. The larger the loan and the longer the repayment terms, the more money lenders stand to earn in interest payments. There are typically two options available to consumers.
- Fixed rate loans
- Adjustable-rate loans
Fixed-rate loans, as the name implies, have a fixed or predetermined interest rate for the duration of the loan term. In other words, the bank's interest rate will remain the same from the first payment of your loan through to your last payment. Adjustable-rate loans, in contrast, have an introductory interest rate (usually lower than a fixed-rate loan). However, these rates are reassessed after a specified term and adjusted periodically, often annually, per the current interest rate as the loan matures.
How Does a Fixed Rate Loan Work?
When you take out a loan with a fixed interest rate, you essentially agree to repay the loan at the predetermined interest rate over the specified period. The attraction of a fixed-rate loan is that you can budget for the monthly payments you'll have to make from the beginning of your loan, knowing that those payments will not increase as long as you maintain the original loan. In contrast, people who take out an adjustable-rate loan are taking a risk. Interest rates could fall over the life of the loan resulting in lower monthly payments. However, the opposite is usually the case, and interest rates increase, meaning monthly payments will increase.
Benefits
There are always risks when borrowing money; fixed-rate loans provide a more significant safety net against rising interest rates. There is some truth to that way of thinking. Remember these essential benefits of fixed-rate loans when exploring your interest-rate options.
- Easy budgeting for the duration of your loan. Your interest rate will not change.
- Eliminates the risk of intense sticker shock if interest rates increase (hint, interest rates were between 0.25% and 0.50% in March of 2022 and between 4.5% and 4.75% in February of 2023). In real-life terms, a 5-year loan on 15,000 at 2.0 percent interest would cost $262.92 per month to repay with a total interest payment of $774.98 over the life of the loan. That same loan at a 4.0 percent interest rate would cost $276.25 per month, and the total interest paid increases to $1,574 over the life of the loan. The larger the loan, the more devastating the swing.
The certainty of knowing what your payments will be over time is a massive relief to many borrowers. Especially those living on budgets or with limited means, which includes practically everyone who needs a loan.
Drawbacks
That doesn't mean that fixed-rate loans are the right choice for everyone. In fact, some find adjustable-rate loans a more attractive option because of the drawbacks that fixed-interest loans represent.
- Fixed-rate loans often have higher initial rates than adjustable-rate loans. For those who anticipate repaying loans early, moving within a fixed amount of time, or who plan to rehab and sell a property quickly, this offers a more attractive option.
- Variable-rate loans can decrease, reducing interest rates. While this is not guaranteed, it is possible – but not for fixed-rate loans, which will remain the same regardless of market trends.
It's about choosing the correct loan terms for your situation and needs.
Using Fixed Rate Loans Responsibly
With any loan, the key is to repay the loan as quickly as possible without incurring fines or penalties for early repayment. Using these loans responsibly requires that you make each payment on time and avoid situations that put your ability to repay at risk. Ultimately, it means avoiding borrowing more than you can afford to repay with your current income and expenses while seeking to minimize new costs once you've taken out the loan.
Alternatives to Fixed Rate Loans
The primary alternative to a fixed-rate loan is an adjustable or variable-rate loan. With a variable-rate loan, your repayment terms will likely change per the current interest rate.
Fixed-rate loans offer security and certainty in repayment, while adjustable-rate loans offer greater volatility and risk. In other words, most long-term consumers find the fixed-rate loan a safer investment strategy.