Variable vs Fixed Interest Rate
The term interest rate is often used in the field of financial management, and it can be often found in the advertisement launched by financial institutions like banks, etc. Interest rate can be defined as a percentage that can either be charged or paid for the use of money. Interest rate is calculated by dividing interest received or paid in a year by the initial principal. Often interest rates are expressed as annual percentage, that is the annual interest rate. Interest rate is an important factor, when making decisions regarding acceptance of projects. According to the interest parity theory, foreign exchange rates can be linked to the interest rates. Power parity theory suggests that interest rates will be changed whenever the inflation in the country changes.
Fixed interest rate
Fixed interest rate means the interest rate that is not changed for a particular period of time. Generally, when someone obtains a loan from a bank, the interest rate that is payable will be the same for a given period of time, depending on the terms and conditions of the loan. In a fixed interest rate, the interest earned can be calculated by multiplying the interest rate and principal. For example, if one has deposited $2000 at an interest rate of 8% for one year, he can earn 8% * $2000 = $160 at the end of one year as interest income. Fixed interest rates give some guide line to make future decision as the payable amount or receivable amount is certain.
Variable interest rate
Variable interest rate is also known as floating interest rate or adjustable rate. What does the floating interest rate mean is that, the interest rate can move up and down based on the changes of underlying interest rate index such as treasuries or prime rate, which reflect the fluctuation of market interest rate. A good example is, many credit cards charge variable interest rate over the prime rate within a specific spread. London inter-bank offered rate (LIBOR) is the rate commonly used as the basis for applying interest rates. Normally, the variable interest rate is denoted as LIOBR +x%. For example, if a customer obtains a loan of $20,000 under the floating interest rate of LIBOR +2% (6months) for one year. Say, at the beginning of the loan period LIBOR is 3%, then the customer has to pay interest at the rate of 5% (3%+2%) for the first six months. At the end of the six months, if LIBOR has moved to 4%, then the customer has to pay interest @ a rate of (4% +2%) 6% for the next six months.
What is the difference between Variable and Fixed Interest Rate?
– Variable interest rate will vary over a period of time, while fixed interest rate is constant for the agreement period.
– Interest rate risk associated with fixed interest rate is less compared to the interest rate risk associated with variable interest rate.
– In general, cost of fixed interest rate is higher than the cost of variable interest rate.
– Interest calculation in floating interest rate is more complex and time consuming than the interest calculation in fixed interest rate.