What is a Fixed Rate Loan?

What is fixed-rate loan?

A fixed-rate loan has an interest rate that doesn’t change throughout the life of the loan. Because the rate remains the same for the entire term, the monthly loan payment shouldn’t change, resulting in a relatively low-risk loan. As you compare loan options, note whether or not loans feature fixed rates.

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

Several kinds of loan products are available on the market, but they boil down to two basic categories: variable-rate loans and fixed-rate loans. With variable-rate loans, the interest rate is set above a certain benchmark and then fluctuates changing at certain periods.

Fixed-rate loans, on the other hand, carry the same interest rate throughout the entire length of the loan. Unlike variable- and adjustable-rate loans, fixed-rate loans don’t fluctuate with the market. So the interest rate in a fixed-rate loan stays the same regardless of where interest rates go up or down.

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.

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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.

A fixed-rate loan has an interest rate that doesn't change throughout the life of the loan.

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.

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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.

3.   student loans

Federal student loans issued after June 30, 2006, have fixed rates. Private student loans may have fixed or variable interest rates.

4. Personal loans

Personal installment loans may have fixed or variable rates. That said, some of the most popular personal loan lenders offer loans with fixed interest rates.

Pros and Cons of Fixed-Rate Loans.

Fixed-rate loans are generally safer than variable-rate loans, but you pay a price for the stability these loans provide. Ultimately, you need to decide what you’re comfortable with and what you think interest rates might do in the future.

Pros

  • Predictable monthly payment through the life of your loan
  • Know exactly how much interest you’ll pay
  • No risk of “payment shock” down the road from increased interest rates

Cons

  • Usually a higher starting rate than variable-rate loans
  • If rates fall, you must refinance or live with your higher rate
  • May not compare well for short-term needs