Fixed Interest Rate

A fixed interest rate is a rate of interest that does not change for an agreed period, which may be a few years or the whole life of a contract. Loans, mortgages, savings deposits and bonds can all carry fixed rates. The borrower knows in advance exactly what each payment will be, and the lender or investor knows exactly what income to expect, whatever happens to market interest rates in the meantime.

The alternative is a variable or floating rate, which moves with a benchmark such as a central bank policy rate, SOFR or KIBOR. A fixed rate transfers the risk of rate changes from the borrower to the lender, and lenders usually charge for that protection. The choice between fixed and floating is one of the most common decisions in household and corporate finance, and the mix in an economy affects how quickly monetary policy reaches borrowers.

Choosing a fixed rate is like buying a season ticket for your train fare. You pay one agreed price for the whole year. If fares go up, you are protected; if they go down, you keep paying the old price. Either way, you know your travel budget in advance.

A variable rate is the pay-as-you-go option: cheaper when prices fall, dearer when they rise. People who value certainty, or who could not cope with a sudden jump in payments, tend to prefer the fixed option, even if it sometimes costs a little more.

A lender offering a fixed rate must fund the loan for the fixed period without knowing future rates. It therefore prices the loan from market rates for that term, usually government bond yields or swap rates, and adds a margin for credit risk, costs and profit. Many banks fund fixed-rate loans with floating deposits and then use an interest rate swap to turn their floating cost into a fixed one, a form of hedging. As a result, fixed rates track the yield curve more closely than the current policy rate. When markets expect rate cuts, five-year fixed rates can be lower than variable rates; when they expect increases, fixes cost more.

Fixed rates are quoted in nominal terms. Their value in real terms depends on inflation: a borrower who fixed at 3% before an unexpected burst of inflation gains, because the debt shrinks in purchasing power, while the lender loses.

For a fully amortizing loan at a fixed rate, every instalment is the same. The standard payment formula is:

• $\text{PMT}$ is the payment due each period.
• $P$ is the amount borrowed (the principal).
• $r$ is the fixed interest rate per period, as a decimal.
• $n$ is the total number of payments.

A 200,000 mortgage at a fixed 6% a year, repaid monthly over 30 years, has $r = 0.06 \div 12 = 0.005$ and $n = 360$. Since $(1.005)^{360} \approx 6.0226$, the payment is $1{,}000 \div (1 - 1 \div 6.0226) \approx 1{,}199.10$ a month for the whole term. Early payments are mostly interest and later ones mostly principal, a pattern known as amortization.

• United States. The 30-year fixed-rate mortgage is the standard home loan, supported by the government-sponsored enterprises that buy and securitize such loans. Most can be repaid early without penalty.
• United Kingdom. Borrowers typically fix for two or five years, then move to the lender's variable rate unless they remortgage. Changes in Bank Rate therefore reach households in waves as fixes expire.
• Euro area. Practice varies: German and French borrowers mostly fix for long periods, while variable rates have historically been more common in countries such as Spain and Portugal.
• Pakistan and India. Most bank lending is floating and linked to benchmarks such as KIBOR, though fixed-rate consumer loans and fixed-term deposits are widely offered.

On the investment side, fixed-rate bonds pay a set coupon rate, and term deposits and certificates of deposit pay a set rate until maturity. The floating equivalents are the floating rate note and variable-rate savings accounts.

• Certainty. Fixed payments make budgeting easier and protect borrowers from sudden rate rises, as many households found when rates climbed sharply in 2022 and 2023.
• Cost of insurance. Fixed rates often include a premium over variable ones, and borrowers miss out if rates fall.
• Exit costs. Leaving a fixed deal early can trigger early repayment charges, because the lender has already hedged the rate. Rules on these charges differ by country.
• Risk for lenders. Holding long fixed-rate assets funded with short deposits exposes a bank to interest rate risk, a problem at the heart of the US savings and loan crisis in the 1980s.
• Policy transmission. In economies with mostly long fixes, interest rate changes take longer to reach households, which economists study as part of the lags in monetary policy.

Borrowers who want partial protection can use caps, split loans or a forward rate agreement to lock in a future rate. In Islamic finance, where interest is not permitted, fixed-profit structures such as murabaha deliver a similar predictable payment schedule.

• Consumer Financial Protection Bureau: Fixed-rate versus adjustable-rate mortgages