Fixed and Floating Interest Rates - Which is Better?

Suppose you need to borrow some loans, like a house loan or a personal loan. In such circumstances, you must select between fixed and floating interest rates. Now, how are fixed interest rates different from floating rates? This post will give you a better understanding of both the benefits and disadvantages of these interest rates. So, without further delay, let's first understand them in brief:

A Brief Understanding of Floating and Fixed Interest Rates

Learning about fixed and floating interest rates at critical times can really help you make wise decisions and improve your financial situation. So, whether you want to opt for a loan or make certain payments, let's educate you about these loan types.

What are Fixed Interest Rates?

Understandably, the loans with a fixed rate of interest are where the interest rate does not change throughout your term. Your interest stays the same even when market rates go up or down. That ensures that you pay the same every month until the last loan payment. It depends on your selected interest rates and for how long you want to pay the loan.

The interest rate is chosen based on what market rates are like at the moment when you get a fixed-rate loan. Usually, if interest rates are low and go up later, it can be a good idea to secure your loan with the current fixed rate.

The interest rate on your fixed-rate loan stays the same even when market rates go up under your agreement terms. However, choosing a floating (or variable) rate loan might give you an advantage. This is when there is a prediction that interest rates will drop in the future. So, when market rates drop, the interest rate on floating-rate loans will also go down. This results in smaller monthly payments. On this note, let's find out a few things about floating interest rates.

What Do You Mean by Floating Interest Rates?

Note that a floating interest rate is a rate that can change from one time to another. That means it may go up or down based on the situation in the financial markets and economy. This kind of rate usually follows a particular index or standard and adjusts according to what happens generally in market trends.

Factors that influence floating rates include the following:

• Economic conditions
• Central bank policies
• Market situation and sentiments

Floating interest rates change based on market conditions or a specific benchmark rate. This might differ based on the loan or type of security. The common benchmarks include the Reserve Bank of India's repo rate or the Marginal Cost of Funds-based Lending Rate.

For consumer loans and other debt like home loans, car loans, or credit cards, banks add extra amounts over the basic rate. This depends on things like the kind of loan and the credit score.

Floating interest rates are common in many types of loans and debts (like credit cards and home loans). They can be good because the rates might go down if market conditions get better. However, they also have a risk; the rates could go up if market conditions become worse.

Pros and Cons of Fixed Interest Rates

Here are the pros of fixed interest rates:

Understanding the Pros

Let's find out the benefits of fixed interest rates:

1. Constant Rate of Interest

Fixed interest rates stay the same (even when the market goes up or down). People who opt for loans with a fixed rate of interest do not worry about increasing rates. Your monthly loan payments stay the same for the time you pay back the loan with the fixed interest rates.

2. No Risks with Increasing Market Rates

When interest rates go up, people who choose fixed interest rates do not need to worry about rising rates. This means that even if interest rates in the economy increase, the rate of the loan stays fixed. It offers financial relief and comfort for people who take out loans.

3. Excellent for Handling Money Effectively

Note that a fixed interest rate helps you make financial planning easier because you always know how much you need to pay every month. Thus, it becomes simpler to keep up with your costs when you have a fixed amount. Therefore, you can plan your money by understanding how much to save for loan payments every month.

Understanding the Cons

Here's a list of the disadvantages of fixed interest rates:

1. Higher Rates from the Beginning

A big downside to fixed interest rates is that the amount might be more than the floating rates in the initial stage. If you choose a loan with a fixed rate, it usually begins with a higher interest compared to the rate you might get from the floating rate. This can make you pay more in interest, especially if market rates go down.

2. No Flexible Rate

Fixed interest rates do not change when market conditions alter. If market interest rates go down, people with fixed-rate loans do not get an advantage from these lower rates. Their loan rate stays fixed at the rate you first agreed upon. So, they may have to pay more interest than people who have loans with floating rates.

3. Penalties for Early Repayment

Many fixed-rate loans get penalties for paying off the loan early. This might be worse for individuals who want to complete their payments before the term ends. These are the charges that lenders ask for as compensation for the interest they miss out on.

Notably, if you complete your payments early, the loan is repaid sooner than you plan. Thus, the lender does not get the total interest you agreed upon during the contract.

Floating Interest Rates – Pros and Cons

Find out the pros and cons of floating interest rates below:

Pros of Floating Interest Rates

Enlisted below are the advantages of floating interest rates:

1. Lower Initial Rates

Floating interest rates begin with lower interest rates than fixed interest rates. This makes them appealing to people, mainly when the overall interest rates are low.

2. A Chance to Save

People who borrow with floating rates can benefit from paying less each month and having lower total interest costs. This is evident when interest rates go down over time.

3. No Prepayment or Penalty

A few fixed interest rates may have penalties if you repay the loan before its term ends. Nonetheless, loans with floating rates are usually more flexible as they do not include any repayment. You can pay them a loan early without any penalties.

You may also read this: Is Early Loan Repayment a Good Idea?

Cons of Floating Interest Rates

Let's find out the disadvantages of floating interest rates:

1. Associated with Uncertainties

The main problem with floating interest rates is the uncertainty they bring to financial planning. It becomes hard to plan a budget well and control finances properly since monthly payments can change when the interest rate changes.

2. Risks of Interest Rates Getting Increased

Evidently, it becomes more expensive to borrow money, which means your monthly payments will be higher when interest rates go up. This risk can result in unforeseen financial problems when rates rise massively over time.

3. Difficult to Compare

Comparing various loan offers with floating interest rates is not easy. Floating rates rely on different reference rates and margins, which makes it more difficult to judge and compare the cost of each loan correctly.

Which is Better – Floating vs Fixed Interest Rates?

The following are the parameters that distinguish fixed interest rates from floating ones:

Wrap up

So, selecting between floating and fixed interest rates depends on how much risk you can handle and how you anticipate the economy. Fixed rates offer stability because they stay the same over time. This makes it easier to know what you'll pay every month. On the other hand, floating rates change depending on market conditions, so sometimes they can be lower than fixed rates.

When choosing a fixed or floating rate, make sure you can handle loan payments easily and think about refinancing regularly. Getting expert advice can also help you choose the best interest rate type (considering your finances).