What Is A Fixed Interest Rate Loan?
A fixed interest loan is a loan that uses a fixed rate of interest to charge a borrower for the money borrowed. Typically, a fixed interest loan is much more popular than its alternative variety, the variable interest rate loan. That's because a fixed interest loan ensures the borrower that the interest rate and thus the loan payments will stay fixed during the entire life of the loan. That means that the risk of interest rates rising, is assumed by the lender, or bank.
How does the bank get compensated for taking this risk(the risk of locking the borrower in at a fixed interest rate)? They charge a premium interest rate that provides them insurance against interest rates rising. Why is it a risk to the bank if interest rates rise? This is a risk to them because if interest rates rise above the interest rate they are charging their fixed rate loan borrowers, then they can't take that money and lend it out at higher interest rates. Thus, they are incurring an opportunity cost if that scenario were to take place.
On the flip side, generally there is less interest charged on a loan that has a variable interest rate. WIth a variable interest rate loan, the interest rate risk is assumed by the borrower and so the insurance premium that the bank charges on fixed rate loans, is removed.
Even still, borrowers prefer the peace of mind fixed rate loans provide, knowing exactly what their monthly loan payments will be each and every month. And that makes sense, as families and individuals operate on a budget, they can't afford to see their monthly living expenses unexpectedly rise if interest rates go up. Then again, if a family was disciplined, they could put away the savings from the variable rate loan, and attempt to insure themselves against interest rate risk.
How Does A Fixed Interest Loan Work?
During the life of a fixed interest loan, the interest and the loan payments remain fixed. Inside of each loan payment, a portion of the payment will go towards interest(paying the lender) and a portion goes towards paying down principal(paying down the loan). At first, most of the loan payment goes towards interest and very little goes toward principal. But over time, this slowly changes and by the end, most of the loan payment goes toward principal and very little goes toward interest. This is called the process of loan amortization. Each of IQ Calculator's loan calculators come with a loan amortization schedule that is split out between principal and interest payments so you can see how this works firsthand.
Different Types of Fixed Interest Loans
Fixed interest loans pretty much operate the same across the board. The primary differences between loans, is what the loan is for and the length or term of the loan. Fixed interest rate loans can be used for everything from auto loans, to purchasing land, to purchasing a home. The possibilities are endless.
Similarly, fixed interest loans can be for any length of time. The most common length of a fixed interest loan is 15 or 30 years when purchasing a home. When purchasing a car or automobile, the typical loan length is much shorter. The loan length and general purpose of the loan are the only two ways fixed rate interest rate loans differ.
Fixed interest rate loans are a great way to mitigate the risk of interest rates going up and causing your loan payments to rise. However, understand that the risk is shifted to the lender and they are likely charging a premium to assume that risk. The alternative is to use a variable interest rate loan where the borrower assumes the interest rate risk. Obviously, this can be a less desirable strategy for getting a loan, but it depends on the borrowers eligibility and their appetite for risk.
IQ Calculators has a collection of fixed interest rate loan calculators for every situation. Here are just a few.
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