Difference between Fixed Rate of Interest & Floating Rate of interest?

Any borrower of money, either an individual or an institution is expected to pay an extra amount over and above the actual amount of loan to the lender at the time of repayment. The extra amount paid is called interest and the actual amount of loan is called principle. Interest to be paid by the borrower to the lender is calculated as a percentage of the principle. Hence, the term Interest Rate.

There are broadly two systems of interest rates charged by banks and financial institutions or any lender following an formal system of lending: The fixed rate of interest and floating rate of interest.

Here is a simple explanation for the two!

Fixed Rate of Interest

When a lender- a bank/ financial institution or an individual lends at a predefined and unchangeable rate of interest to be paid by the borrower on the principle (amount of loan) for the duration of loan irrespective of what happens to the interest rates in the country in the future, the rate of interest is said to be fixed.

Fixed rate of interest is a better choice for a lender if he expects a fall in the interest rates in the future. So, he would profit from receiving a higher rate of interest even when the general interest rate levels are down in the future. On the contrary, this would be beneficial for a borrower if he expects the rates to rise in the future. In this case, he would enjoy paying a lower fixed interest rate irrespective of the higher rates in the future.

Floating Rate of interest

Let's say that at the time of lending, the lender specifies the interest rate (to be paid by you) on your loan to be LIBOR+2%. This means that your interest rate is not fixed but rather variable. It may rise in the future if the LIBOR rises and fall if the LIBOR falls thus requiring you to pay more and less in the cases respectively. Thus, under this rate of interest the rates are completely dependent on the base – LIBOR.
Going by the same logic as above for a lender, floating rate of interest is ideal if he foresees a rise in the interest rates in the future but for a borrower it is rational to choose a floating rate of interest if he expects a fall in the interest rates in the future.

What are fixed and floating rates of interest?
Which is better, a fixed or variable rate loan?

Fixed vs Floating Interest Rate – Which Suits you The Best

From the above you may realise that you should opt for a fixed rate of interest for your loan if you are expecting the future rate of interest in your country to be higher than they are now and choose a floating rate of interest if you are expecting a fall in the interest rates in the future. The exact converse will be true in case of a lender.

You would know this if you're reading the newspapers or financial tabloids that discuss about the future plans of the Central Bank of your country or your lending bank/ institution. If there are signs that the Central Bank or your lending bank is likely to rise the rates of interest, you as a borrower should know that a fixed rate of interest is what you must choose today.

Read More:
What are Interest Rate Swaps(IRS) | What happens in Interest Rate Swap ?
How are Open Market Operations (OMO) and bond yields related?
3 Types of Insurance You Don’t Need to Buy
EDI: Pros and Cons of Electronic Data Interchange

Copyright © ianswer4u.com