While repaying back a loan, it is a bit complex to understand the appropriate loan interest rate to take on. Not everybody understands the algorithm between a variable and fixed interest rate. A few experts in the banking sector explain the concepts.
Variable interest rate
A variable interest rate, also referred to as a floating interest rate, is where the interest on a loan moves up and down depending on the underlying base index on which it is benchmarked. It fluctuates over time as it is based on an underlying index that changes periodically, defines Guy Kimbowa Lutaaya, the head of credit at Absa Bank.
As an example, if a bank has its base index on which it benchmarks its interest rate as being the Central Bank Rate (CBR) – whenever the CBR moves either up or down, the variable interest rate on the loan will move in the same direction.
Fixed interest rate
A fixed interest rate is where the interest rate on a loan remains unchanged during the entire term of the loan. As an example, if you get a loan at 15 per cent per annum at a fixed interest rate for five years – that is the same rate that you will pay for the entire duration of the five-year term, regardless of whether CBR moves up or down.
“In short, the difference between the two is clear. For the variable interest rate, the rate is subject to change [so the loan instalment that you pay can vary from time-to-time] and for fixed interest rate the rate remains the same for the duration of the loan or credit facility (the instalment that you pay is fixed from when you start to pay the loan to when you finish paying the loan.)”
On the other side of the coin, each these interest loans, Lutaaya emphasizes, have pros and cons. But looking at it from the lens of a personal borrower that might not have access to sophisticated hedging instruments like Interest Rate Swaps (IRS) – that borrower might prefer certainty and predictability with their instalment payments so the fixed interest rate might edge out the variable interest rate.
Whereas variable interest rate is suitable if the rate goes down, the borrower benefits from the reduced rates by paying less on his / her loan instalment.
However, if the rate goes up, the borrower will have to pay more on his / her loan instalment.
The variable interest rate might go up to a point where the borrower can have difficulty paying the loan;The unpredictability of variable interest rates makes it harder for the borrower to budget
Fixed interest rate remain the same for the duration of the loan so it’s easier for the borrower to budget.
During periods of low interest rates, the borrower can lock in a lower rate for the duration of the loan.
Stephen Kaboyo, a financial markets consultant says fixed rate loans are more appealing to borrowers during periods of low interest rate environment. The main advantage is that it eliminates the risk of a loan repayment increasing overtime because of its locking in nature.
However, during periods of high interest rates, the borrower is locked in at a high rate for the duration of the loan; and doesn’t benefit when the general interest rates come down, unless he / she tops up the loan during periods of low interest rate.
Factors that affect the interest rate
Notably Lutaaya, outlines some factors that affect the interest rate that include; Cost of Funds (COF), the cost at which the bank raises the funds that it lends out. When the funding cost is high, it tends to affect the interest rate adversely.
He adds, credit default premium represents the quality or credit worthiness of a particular borrower to which the raised funds are advanced.
High quality or credit worthy customers tend to pose a lower credit risk, hence they typically get more favourable interest rates.
Liquidity risk premium represents the time value of money; which is the period that the borrower holds the advanced funds. Typically the longer the period, the higher the premium.
Lutaaya adds also, operational costs of maintaining the loan, represents the costs incurred by the bank in the management and monitoring aspects of the loan and it is performance.
If that cost-to-serve is high, then that would also factor into the interest rate as well.