When you are searching for personal loans, credit cards or mortgages, you may witness financial terms, which may be completely new to you. The term “Interest Rate” may sound familiar. But what if someone tells you that the mortgage you are applying for will have a variable interest rate? Or, the personal loan you are about to borrow has a fixed interest rate. Interest rates can be confusing when it comes to personal finance.

We have explained about fixed interest rates to make things easier. Read to know more.

What is an interest rate?

An interest rate is an amount that is charged on the amount that you borrow. Banks, private lender and other lending institutions offer a rate of interest when you decide to take out a loan. It is measured as a percentage of the amount of the loan (or deposit) that a borrower has to pay annually to the lender.

Interest rate when you are borrowing money

When you borrow the money you are required to repay the amount that you have borrowed along with the interest rate. That means you have to compensate for the risk that the lender is taking by lending money to you.

Interest rate when you have a savings account

If you deposit the funds in your savings account, you will earn interest on the money that you have deposited. Because banks will use your money to lend to their customers and in return, they will provide you interest.

What is a fixed interest rate?

A fixed interest rate means the rate will not fluctuate throughout the loan term. Generally, with a variable or floating interest rate loan, the monthly payment varies according to the rate of interest. There are chances you will have to pay way more than you had borrowed.

A fixed rate of interest is an attractive offer for the borrowers as they will know how much the loan will cost them before borrowing it. This will help them in planning their repayments and rework on their monthly budget.

Should I choose a variable or fixed interest rate loan?

Variable, floating or adjustable interest rates change periodically. The borrower receives an interest rate that is set for a specific period after which it will change according to the base rate set by a central bank or any other benchmark index.

Let us take an example to make things clear:

You borrow a mortgage at 5% interest rate (adjustable) on a £30000, 20-year mortgage. Your monthly payment will be £196.15 during the first few years of the loan. But the payment may increase or decrease when the rate adjusts, based on the interest rate set by the Bank of England or LIBOR. If the rate adjusts to 8%, your monthly payment will increase by £49.6. That means you will have to pay £245.75 each month, which might be tough to manage. But the monthly payments would fall to £212.19 if the rate dropped to 6%.

If, on the other hand, the 4.5% rate were fixed, you will have to pay £188.34 payment every month for 20 years.

Borrowers opt for fixed interest rate due to fixed monthly payments that help them to prepare a budget beforehand. Also, the risk of paying more during the loan term is less with a fixed interest rate loan.

A variable interest loan may be good for you if you are planning to refinance in the short-term. Initially, the interest rates on an adjustable interest rate loan may be low, but when the rate starts adjusting, you may have to pay way higher than what you had planned for.

Can I pay a fixed-rate loan early?

Generally, lenders charge a prepayment penalty if you decide to pay off the loan before the agreed date. That is because the lenders will lose their money that they would have earned on the interest. To compensate that loss, they charge borrowers with an early repayment fee.

If you feel that the current loan that you have has a high rate of interest, you may consider refinancing it. Switch to a personal loan with a low-interest rate to save money and bring back your finances on track.

Whether you will be charged an early repayment fee or not depends on the lender. Here are 5 Do’s and Don’ts of repaying a personal loan early.