Lesson Fixed and Floating Interest Rates

The interest rates to be paid on a loan/debt can be of two broad types:

1. Fixed Interest Rate
2. Floating Interest Rate

Fixed Interest Rate: In fixed interest rate the interest to be paid is fixed in advance when taking the loan/debt. Thus the borrower knows the exact amount he needs to pay in the future or at least he knows the exact interest rate to pay for the outstanding loan at that time. For example, if a person borrows money at fixed interest rate of 10% per annum for five years, then he/she would need to pay an interest of 10% on the outstanding principal every year. Fixed interest rate is beneficial for a person who would like to know his future cash outflows in advance and plan accordingly.

One thing to keep in mind for fixed interest rate is that it is not necessary that the interest rate remains same for the whole period of borrwing. The interest rate just needs to be fixed and known in advance. For example a person may borrow $10,000 for three years at an interest rate of 5% for first year, 6% for second year and 7% for third year. These rates are fixed in advance.

Floating Interest Rate: In case of floating interest rate, the interest rate is not determined while borrowing/lending, but is dependent on some underlying. For example, a person may borrow $10,000 at an interest rate of LIBOR + 1% per annum. LIBOR is the London Inter Bank Offer Rate, i.e. the interest rate at which the banks are ready to borrow money. This rate keeps on changing on a per day basis and thus the interest rate at which the person borrowed would keep on changing. However, the change is not made on a daily basis but is done once a year/six months and the interest rate is thus fixed till the next update.

The calculation of the fixed interest rate is actually based on the future expectation of the floating rate and the loans are issued in a manner that the present value of the loan at fixed interest rate is same as the 'expected' present value of the loan at floating interest rate, other things being same. The expected floating rates are published by many agencies, which aid in this calculation.

By taking a floating interest rate, both the borrower and the lender are exposed to a certain degree of risk. If the future interest rates turn out to be lower than the expected interest rates, then the borrower will benefit, since she would have to pay lower than if she would have chosen fixed interest rate. In the other case, the lender will benefit.

Choice between fixed and floating interest rates

Investor: If you are an informed investor and hold a view on the future interest rates which is different from the market, there is merit in opting one strategy over the other for making monetory gains. For example, if you feel that future interest rates are going to be higher thatn what are being projected by analysyts, there is a chance to make money by lending at floating rate and borrowing at fixed rate. The present value of the floating rate according to your views would be higher than that of fixed rate and you would thus end making money. On the other hand, if you feel that the interest rates are going to be lower than expected, there is merit in borrowing at floating rate and lending at fixed rate.

Personal loans: If you are borrowing for personal usage and are not aware of the market dynamics, it is safer to opt for fixed interest loans since you would be aware of the interest rate to be paid in coming years in advance and would be protected against sudden rise in the same. However, if you have a good appetite for risk and have a view that interest rates are likely to fall, then opting for a floating rate loan is not a bad strategy.