How fixed interest rate borrowing works
A fixed interest rate is an interest rate that doesn’t change, making payments predictable.
There are many financial products out there which offer a fixed rate of interest. If it’s a loan, such as a mortgage, personal loan or even a credit card, a fixed rate of interest means the interest charged on the debt should remain the same for a specified period, so long as you follow the terms and conditions of the loan.
If you have a fixed rate savings account, it means the interest rate you receive is guaranteed for the term of the product.
Here we explain exactly what fixed interest rates are and how they work.
What is a fixed interest rate?
A financial product with a fixed interest rate has an interest rate that won’t change for a specified period of time. For example, a five-year fixed rate mortgage has an interest rate that will not change for five years. A two-year fixed rate savings account will pay the same level of interest for two years.
The alternative type of interest rate is a variable rate. This type of rate changes and can go up or down. This means the amount of interest you pay on a loan (or any other financial product) can change over time.
On the whole, the longer you choose to fix the interest rate on a loan, the more expensive it is likely to be. This is because lenders don’t know what will happen with the economy and wider financial markets so they risk losing out if they set the interest rate too low.
Conversely, fixed rate savings accounts, which restrict access to your funds, offer higher interest rates on longer terms. So, the longer you are prepared to keep your money locked away, the higher the interest rate you are likely to get.
What types of products have fixed interest rates?
Lots of financial products have fixed interest rates including the following:
- Personal loans
- Student loans
- Car finance agreements
- Credit cards (although it’s more common for these to have variable rates of interest)
- Savings accounts, such as bonds
- Cash ISAs
Pros and cons of fixed interest rates
If you are able to choose between a fixed and a variable interest rate, it’s worth looking at the pros and cons.
Pros of fixed interest rates
- With loans you’ll always know how much you have to pay in interest as the payments remain the same.
- With mortgages,your rate won’t change even if the Bank of England’s (BoE) base rate increases.
- It’s easy to compare products.
- You’ll never pay out more in interest than the set amount.
- With savings accounts you are likely to get a higher rate of interest if you are prepared to go for a fixed-rate account.
- With savings accounts your fixed rate will look more attractive if the interest rates offered go down.
Cons of fixed interest rates
- Loans may be more expensive than those with a variable interest rate.
- With mortgages,you may lose out if the Bank of England’s (BoE) base rate falls.
- Lenders have the power to change the terms of the rate if you aren’t fulfilling a credit agreement, such as if you miss payments.
- With savings accounts your fixed rate might start looking less attractive if the interest rates offered go up.
How fixed interest rates are calculated
Financial services companies usually decide upon a fixed interest rate and this should be shown to you before you take out the product. You can easily check one rate against what other providers are offering to find the best rate for you.
With loans it’s also easier to work out how much they will cost overall. For example, if you take out a five-year loan with a fixed rate of interest you’ll know exactly how much in interest you’ll be expected to pay. Whereas if it has a variable rate of interest, the rate of interest (and therefore repayments) could change during this time.
What’s the difference between fixed and variable interest rates?
Fixed interest rates stay the same while variable rates of interest can change. Here is an example to demonstrate the difference between these interest rates:
If someone took out a five-year mortgage with a fixed interest rate of 3%, this would be the set amount of interest they would pay for the full five years. However, if the same person took out a variable-rate mortgage, the rate of interest could fall below, or rise above, 3% at any point.
There are some circumstances whereby a fixed rate of interest may change. This tends to only happen if you’ve broken the conditions of the agreement, such as missed or made late payments. However, you should be told about this in the terms and conditions.
When is a fixed interest rate a good idea?
When borrowing, a fixed interest rate allows you to plan for reliable, predictable repayments on your loan. This can be helpful if you are managing a tight budget or have specific financial goals that can’t account for the risk associated with a variable interest rate.
If the economy is unsettled and rates change, choosing a fixed rate of interest on a new loan means you’ll have the peace of mind of knowing the rate won’t change. If you were to take out a variable rate of interest instead, and UK interest rates increase, your interest payments could also increase, making the loan much more expensive.
On the other hand, if you have a fixed rate of interest on a loan, and UK interest rates fall, you’ll still pay the same rate of interest until the loan is paid off. While if you had chosen a loan with a variable rate of interest, you may see your interest rates falling inline with the UK interest rate, resulting in cheaper borrowing.
When saving, a fixed interest rate allows for high returns of interest on your deposit. If you take out a fixed-rate savings account and interest rates rise, your bank or building society won’t pay you any more, whereas if you have a variable rate savings account the rate you get may go up. By contrast if interest rates go down, the rates paid on variable savings accounts are likely to go down while those with fixed rate savings accounts will carry on receiving the same rate.
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Rebecca Goodman is a freelance journalist who has spent the past 10 years working across personal finance publications. Regularly writing for The Guardian, The Sun, The Telegraph, and The Independent. Read more