Interest rates can make the difference between a good deal and a great one when it comes to approaching your bank, but what about a fixed interest rate? Explore fixed interest rates right here.
Fixed interest rate definition
A fixed interest rate is a rate that doesn’t change for the duration of your loan, or at least for a specific period. UK banks regularly employ fixed interest rates for mortgages and savings accounts. For example, banks will offer a 5% fixed interest rate on your savings for one year, which then drops to 1% or less. In many cases, this interest isn’t paid until the account matures, so it’s essentially a “golden handcuff” ensuring you remain a customer for at least a year.
How does a fixed interest rate loan work?
A fixed interest rate loan means you will only have to pay an agreed amount of interest for a set amount of time – for example, one year. The opposite of this would be variable credit. The following sorts of loans may all come with offers of fixed interest rates:
Home equity loans
With a fixed interest rate, interest is added to the amount you borrowed (known as the principle amount). Each repayment covers both interest incurred and a portion of the principle repayment. For credit, fixed interest can help control the extra fees that accompany late payments, though you shouldn’t enter a credit deal if late payment is likely to be a regular occurrence.
Banks and lenders are required to tell you what sort of rate you’re signing up for. Be aware that the bank can change the interest rate at any time, but this should also be outlined in the small print. You may also be given a breakdown of your payments over the fixed period, so you can see how much you will pay each month.
How to calculate fixed interest rates
You can calculate how much your payments will be using the following interest formula:
(Interest Rate / Number of Payments) x Loan Principle = Interest
So, if you borrow £40,000 on a 10-year loan at 5% interest a year (that’s 12 payments per year), you would do the following:
(0.05 / 12) x 40,000 = £166.66
You can use the following formula to work out what remains on a loan that you have already started to make repayments on:
Principle – (Repayment – Interest) = New Balance
For example, if you have already paid back £5,000, the equation would look like this:
40,000 – (5,000 – 5%) = £35,250
You can use this formula to forecast your repayments for as long as your fixed interest rate period lasts, as it won’t change on a month to month basis.
Fixed vs. variable interest rates
Variable-rate interest is the opposite of a fixed interest rate because it can change at any time. Variable interest rates are based on the national interest rate or bank rate set by the Bank of England. Some businesses may prefer to take their chances with this type of rate, as it can go down as well as up, meaning that they may get away with paying less. There is no guarantee that things will work out this way. Even if you stand to save in some months, you can guarantee you’ll be spending more at other times throughout the year.
What affects the interest rate?
The interest rate can change at any given time, depending on global events. For example, a financial crisis will see more people in financial hardships and therefore need to borrow more money from banks. A lower interest rate allows people to borrow more and get more for their money, but saving will be less rewarding. Lower interest rates are used by the Bank of England to help support an economy in crisis.
Why should I pick a fixed interest rate?
Fixed interest rates won’t change for the duration of the agreed term, which can be extremely useful for planning your finances. While it’s not a risk-free interest rate, it’s a safer choice if you need to know what to budget each month. In many cases, businesses that require a loan aren’t in the best position to deal with payments that change every month. A fixed interest rate ensures that your costs will always be the same.
Why is the interest rate significant?
As mentioned above, the interest rate impacts how much you will be paying back each month. A fixed interest rate can be very beneficial for people who need the stability of a fixed price. For those who are happy to risk paying more on the chance that they may also end up paying less, a variable rate may be more suitable. Interest rates are one of the major factors to consider when looking for a loan of any kind, so if you want to keep as tight a grip on your company’s outgoings as possible, a fixed interest rate can help remove any unpredictability.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.