What is a Fixed Interest Rate?
A Fixed Interest Rate remains constant for the entirety of the loan agreement, as opposed to being tied to a prime rate or underlying index.
- What is a fixed interest rate?
- How does a fixed interest rate differ from a floating interest rate (i.e. variable)?
- Which type of debt instruments are typically priced at fixed rates?
- When might a fixed interest rate be preferable over a variable rate?
Table of Contents
Fixed Interest Rate Definition
If a loan or bond is priced at a fixed interest rate, the interest rate – which determines the interest expense amount due each period – is fixed and does not fluctuate over time.
The distinct benefit of fixed rates is the predictability in the pricing of the debt, as the borrower does not need to be concerned about changing market conditions that may impact the interest due.
The fact that the interest rate is fixed mitigates any risk that the borrower’s interest expense payments could increase substantially.
Typically, borrowers are more likely to opt for fixed interest rates in lending agreements during low interest rate environments in an attempt to “lock-in” a favorable long-term rate.
Fixed Interest Rate Formula
- Interest Expense = Fixed Interest Rate * Average Debt Balance
Fixed vs Variable Interest Rates Difference
Unlike fixed interest rates, variable interest rates fluctuate based on the underlying rate that is tied to the pricing of the debt (e.g. LIBOR, SOFR).
For debt priced at a floating rate:
- If the market rate declines, the borrower benefits from the lower interest rate.
- But if the market rate rises, the lender benefits from the higher interest rate.
Floating interest rates thus can be a riskier form of debt pricing with more uncertainty because of the unpredictable changes in the underlying benchmark.
If the debt is priced at a fixed rate, the original interest rate remains the same, which eliminates any concerns from the borrower regarding how much interest will be owed.
However, a fixed rate comes at the expense of not being able to benefit in lower interest rate environments.
For example, if the benchmark rate is lower and the lending environment becomes more favorable for borrowers, interest expense on a bond priced at a fixed rate would still stay unchanged.
Fixed Interest Rate Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Fixed Interest Rate Example Calculation
In our illustrative example, we’ll assume there is a senior note with a total outstanding balance of $100 million.
For the sake of simplicity, there’ll be no mandatory amortization or cash sweeps (i.e. optional prepayments) across the forecast period.
For a variable interest rate, a spread is added to the market rate (e.g. LIBOR) for each corresponding year.
But in this case, the senior notes are priced at a fixed rate of 8.5%, which is kept constant for the entirety of the forecast and multiplied by the average between the beginning and ending balance.
Since the balance of the senior notes does not change at all throughout the four years, the interest expense stays at $8.5 million every year as shown below.