How Fixed Rate Loans Work: Cost Security

Fixed interest rate loans have interest rates that do not change over time. Getting a fixed rate is a good “default” option because you always know what your costs (and monthly payment) will be.

When you borrow money, you pay for the loan by paying interest. There may be a few more fees, but interest is usually the main driver of how expensive a loan is: higher costs mean higher costs. That is why it is important to understand how your rate works and if your rate may change.

What are the fixed interest rates?

What are the fixed interest rates?

Loans can come with variable interest rates that change over time or fixed rates. At a fixed rate, you pay the same (unchanged) interest rate for the duration of your loan. This is important because the interest rate affects how much your monthly payment will be: if the rate increases, your required monthly payment could also go up – and you may not be able to afford those higher payments.

Moreover, the increased interest rate will also raise the price of what you bought with the money borrowed. You will spend more on interest but you will not get more than what you bought.

To see an example of how numbers change at a higher rate, include some numbers in your loan amortization calculator: You will notice that a higher rate leads to higher monthly interest costs (and higher payments).

Interest rates are constantly changing as the economy grows and contracts are reached.

At a fixed rate, your loan is immune to these changes.

Secure loans at cost

Secure loans at cost

Fixed-rate loans are generally safer than floating-rate loans: you know what to expect, and you can plan for the future. There are countless stories of borrowers who have suffered a “shock shock” when interest rates on floating-rate loans have risen.

But you have to pay for security – security does not come for free. Fixed-rate loans typically start at higher interest rates than variable-rate loans.

For example, a fixed-rate mortgage rate may be one or two percent higher than an adjustable-rate mortgage (ARM) rate. That difference can make dramatic changes to your monthly payment – and it’s often tempting to go for a lower payment (with a variable interest rate variant).

When fixed rates fail

Drop rate: Sometimes a fixed-rate loan is the wrong choice – but you will rarely know it in advance. If interest rates fall after you get a loan (and stay lower for a long time), a variable-rate loan might be a better deal. Unfortunately, time interest rates are perfectly extremely difficult. That said, if interest rates are at historically high levels and are expected to fall – and you are getting a long-term loan such as a 30-year mortgage – it might make sense to at least consider a variable-rate loan.

Refinancing: If rates go down and you have fixed-rate credit, it’s not the end of the world. You can always try to refinance into a cheaper, lower loan. However, you will need to qualify for a new loan, and your situation (credit scores, debt-to-income ratios, etc.) may change.

In many cases, you will have to pay closing costs, and these costs will reduce any benefits you receive from refinancing.

Short-term commitment: Fixed rates can (sometimes) be less attractive when borrowing for a short period of time. Since they automatically come at higher rates than variable-rate loans, it is worth estimating how long you will keep the loan. Some floating-rate loans retain the same initial rate for five years.

If you expect to get rid of a loan before then, it might make sense to go for a lower (variable) loan. Unfortunately, life does not always work out as planned, so you need some security and good luck to make this strategy worthwhile.

Types of fixed-rate loans

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How can you get a fixed-rate loan? These loans are easy to find. A standard 30-year fixed-rate mortgage has traditionally been the most common way to buy a home.

If you are going for a mortgage of 15 years, you may get a rate that is competitive with the adjustable-rate mortgage. Interest-only loans can also have fixed rates (but are risky to use).

Car loans and federal student loans are often fixed-rate loans: you get a monthly payment that does not change, and over time you pay off the loan balance.

Many personal loans also include fixed rates, but credit cards are an important exception. With credit cards and other credit lines, your rate often changes (sometimes not in your favor).