A type of loan with an interest rate that remains unchanged for the entire term of the loan
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What are Fixed-Rate Loans?
A fixed-rate loan is a type of loan where the interest rate remains unchanged for the entire term of the loan or for a part of the loan term. Most borrowers prefer fixed-rate loans for long-term loans since they can accurately predict future costs and monthly payments.
For example, when taking a 15-year mortgage to buy a house, a borrower would prefer taking a fixed-rate loan to avoid the risk of interest rates fluctuating during the term of the loan, thereby increasing the mortgage payments.
Summary
- A fixed-rate loan is a type of loan with an interest rate that remains unchanged for the entire term of the loan.
- Fixed-rate loan borrowers can predict their future payments with accuracy since the payments are not affected by future changes in interest rates.
- Examples of fixed-rate loans include auto loans, personal loans, fixed-rate mortgages, and federal student loans.
How Fixed-Rate Loans Work
The interest rate for a fixed-rate loan remains fixed for the term of the loan, and it does not change with changes in interest rates or inflation. It means that the loan costs and monthly payments will remain the same during the entire period of the loan.
The decision on whether or not to choose a fixed-rate loan will depend on the term of the loan and the prevailing interest rate environment. An increasing interest rate increases the amount of monthly payments by the borrower. Variable interest rate changes as the economy grows, while fixed interest rates are immune to the changes in the economy.
If the current interest rate is low but is expected to increase significantly in the future, a fixed-rate loan is preferred over a variable-rate loan. A fixed-rate loan locks the loan at the then-prevailing interest rate and protects the borrower from future changes in interest rates.
On the contrary, if the interest rates are expected to decline in the future, it is better to go with a variable-rate loan to benefit from lower loan costs. Taking a fixed-rate loan in such instances will make the loan expensive, and the borrower will need to contend with higher interest rates than the actual interest rate.
Types of Fixed-Rate Loans
The following are the most popular types of fixed-rate loans:
1. Auto loans
An auto loan is a fixed-rate loan that requires borrowers to make fixed monthly payments over a specific period of time. When a borrower applies for an auto loan, they are required to pledge the motor vehicle being purchased as collateral. The borrower and the lender also agree on a pattern of payments, which may include a down payment and periodic payments of principal and interest.
For example, assume that a borrower borrows $20,000 to purchase a truck at an interest rate of 10%, payable over a two-year period. The borrower will be required to make periodic monthly payments of $916.67 for the entire period of the loan. If the borrower makes a down payment of $5,000, he/she will be required to make monthly payments of $708.33 for the entire term of the loan.
2. Mortgage
A mortgage is a type of fixed-rate loan that borrowers take to buy a property or real estate. In a mortgage agreement, the lender agrees to provide cash upfront in exchange for fixed monthly payments over a period of time. The borrower uses the loan to purchase a home and then provides the property as collateral for the loan until all the loan is paid up.
For example, a 30-year mortgage is one of the common types of fixed-rate loans, and it comprises fixed monthly payments that are spread over a period of 30 years. The period payments are the payments made towards the principal and interest of the loan.
Fixed-Rate Loans vs. Variable-Rate Loans
Both fixed-rate and variable-rate loans come with their own merits and demerits depending on the interest rate environment. Depending on the loan term and expected interest environment, borrowers can opt to take either a fixed-rate or variable-rate loan. Home loans provide borrowers with several interest rate options. Borrowers are given the option of choosing a home loan with fixed interest, variable interest, or a hybrid of both fixed and variable interest rates.
An example of a loan that combines both fixed and variable rates is the adjustable-rate mortgage. The borrower receives an introductory interest rate for a specific period of the loan term. Afterward, the loan adjusts periodically to reflect the changes in the economy and the Federal Reserve lending rate.
An adjustable-rate mortgage is usually advantageous in a decreasing interest rate environment since the rate will adjust with the changes in interest rates. The 5/1 adjustable-rate mortgage is the most popular adjustable-rate mortgage product. It begins with an initial five-year interest rate, followed by an adjustable interest rate that adjusts once per year.
If interest rates rise after the initial five-year period, borrowers will need to pay higher interest rates than what they paid during the initial five-year period. The adjustment is based on an index plus a margin on the interest rate.
Additional Resources
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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:
