Definition & Meaning:

On some bank loans, the amount of money you are charged in interest never changes during the whole time that you are repaying the loan (you pay exactly the same each month). If this happens, you are paying a 'fixed interest rate' on the money you have borrowed.

For a borrower, is this a good way to borrow money? The answer is, it could be. But you could end up paying more money in interest than if your loan had a different type of interest rate.

Before I explain why, you need to understand something first; the value of money is constantly decreasing. This decrease is what is called 'inflation'. This decrease in the value of money is not constant, it changes over time (some times the amount of decrease is more and at other times less). So, interests rates which are not fixed change to reflect the rate of inflation.

It may come as a bit of a surprise to you, but for banks to be able to lend money, they have to borrow money themselves from their customers and other banks. And the interest rate that they have to pay changes not only due to inflation but the level of demand there is to borrow money in the economy (generally, the higher the demand to borrow money, the higher the interest rate).

When you take out a loan which has a 'fixed interest rate', the banks use both the rate of inflation and the cost to them of borrowing money at that time and how they expect them to change in the future as factors in determining the interest rate you'll pay them for the loan.

But if the banks predictions are wrong, it could mean the amount of money that a bank earns from lending money with a 'fixed interest rate' could either rise or fall. For example, if the interest rate and inflation is higher than they expected when they gave out a loan, they will earn less money and visa versa). So, this make 'fixed rate' loans a risky way to lend money for banks.

For a borrower, although having a 'fixed interest rate' on a loan is less risky (you interest payments don't change), there is the possibility that you could end up paying more money in interest than if you had a loan which has an interest rate which did change, called a 'variable interest rate'. But conversely, you could also end up paying less money in interest.

This is something you need to think about when deciding which type of interest rate you choose to repay a loan with.

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Also Called:

Fixed Rate.

Related Vocabulary:

Annual Percentage Rate, Redemption Penalties, The Principal, Variable Interest Rate, Split Interest Rate, Preferential Interest Rate.

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