One thing that I’m quickly learning as I take on more financial responsibility such as loans, mortgages and auto payments is that there is a lot of new jargon and financial concepts that are new to me. One concept that I recently faced was fixed and floating interest rate loans.
Before becoming a borrower, I simply believed that there was an interest rate, and you pay it for the duration of your loan, unless you considered consolidating your loans.
But now I’ve learned that interest rates on loans and bond investments can be fixed or floating and which one is preferable are depending on specific situations. Unfortunately, which one is best is also dependent on reading the future. Choosing a floating rate might benefit its borrowers and investors but it might not.
Fixed Interest Rates
These are the type of loans that I was always familiar with. Fixed interest rates are loan rates that remain the same for the loans entire term, regardless of what the markets Interest rate derivatives are. Generally, you would choose a fixed-rate loan dependent on the markets environment at the time when your loan is taken and on the duration.
Floating Interest Rates
A variable, or floating, interest rate loan is one that moves up and down with the market or an index. Therefore, the interest rate is not determined while borrowing but rather is dependent on an underlyer. For example, a person might borrow £15,000 for London Inter Bank Offer Rate (LIBOR) + 1% per annum. LIBOR is the interest rates at which banks are ready to borrow money. This rate changes daily and subsequently, so would the interest rate but the rate is only updated about every 6 months – 1 year.
Choosing Between Fixed and Floating Rates
I was surprised when I realised that these two concepts are so important to the global financial sector that large businesses, investors, portfolio managers, banks, etc. use Interest rate swap claims to exchange one interest rate for another to obtain a better rate and preferred fixed or floating type. They will use clearing houses to safely make Swaps; one interest rate for another.
But I was curious: which is best for me?
Floating-rate mortgages often have lower rates than fixed rates, which could make them ideal for a loan that is quickly repaid. However, when your rate is dependent on vague speculation of the future interest rates in 5 years, the floating rate becomes a larger risk and perhaps not worth its lower rate.
Therefore, as somebody who is taking out a personal loan for a residential mortgage and you’re not a follower of the Derivatives market, then opting for fixed interest rates would be a safer option. If you have an appetite for gambling and believe that interest rates will fall then a floating rate might be the right strategy.
That being said, for investors, portfolio managers, bankers, etc. and have a great understanding on the future of interest rates then to obtain a better rate and gain money then there is sound strategy in investing in a certain strategy.
Interest rates are as intrinsic to financial responsibility as growing up is to life. What I’ve learned is that as you grow old and gain more financial responsibility and start borrowing and investing money, new jargon and financial notions are going to come. Take them one step at a time.