What is... | August 29, 2011

What is a fixed rate?

For borrowers and savers alike, one of the most important parts of a financial transaction is the interest rate. Whether getting a savings account, credit card, mortgage or bank loan, choosing between a fixed, variable or other type of interest rate is key.

Is it best to fix a rate (or not)? That will be determined by individual circumstances.

In a fix
A fixed rate means that the interest rate a customer receives on investments or pays on loans will not change over the length of the agreed term.
At a more technical level, fixed rates tend to be influenced by the interest rates on corporate or government bonds (because bonds reflect interest rates available in financial markets for anywhere between one year and 30 years). The eZonomics video How bonds work explains bonds in more detail. An advantage of a fixed rate loan is the certainty about the size of repayments. Likewise, investments with fixed rates offer certainty about the income. Such knowledge can make budgeting easier.

Time is money
Savers may get higher interest rates from locking their money away in a fixed deal. This higher rate is largely because lenders also value certainty and knowing they will have funds for a set term can be valuable for their planning. Economists have a theory called the time value of money, which argues that ready access to money has value. Higher interest rates for fixed terms reflect the time value of money.

Swings and roundabouts
Borrowers on a fixed deal might end up with a higher rate of interest than those on a variable (floating) rate – but be aware, the reverse is also possible. They could end up paying less if circumstances work in their favour. Variable rates usually change when a country's central bank changes official interest rates. For borrowers on a fixed rate, a fall in variable rates might see them paying more than those with variable rate loans. Conversely, savers on a fixed rate may do less well when variable rates rise.

Watch out for...
A disadvantage with fixed interest arrangements is that they often come with penalties attached if you try to change the deal before the agreed time. As a result, fixed rate deposits are not suitable for keeping emergency savings funds, which may need to be called on at short notice. For mortgage borrowers, the penalty involved in breaking a fixed rate agreement may mean paying the lender a fee, usually equal to several months' interest to get out of the deal. For savers it usually means missing out on several months' interest.

InvestingPersonal finance

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics