We often think that the names themselves, variable and fixed interest rate, explain the difference. Let’s check if that’s really the case and why variable interest rates are usually more favourable than fixed rates. We will start with a basic explanation of these two terms and make a comparison between two loans, one with a fixed interest rate and the other with a variable interest rate, in two different scenarios.
Fixed interest rate
Variable interest rate
Why is variable always better at the start than fixed?
Conclusion
Fixed interest rate
A fixed interest rate does not change during the duration of the loan agreement. It is usually slightly higher than the variable rate, but it does not carry the component of interest rate risk. In short, the interest rate you agreed upon at the beginning of the loan remains the same until the end of the loan term.
The advantage of a fixed interest rate is that if market interest rates increase, your interest rate remains the same. The disadvantage is that if market interest rates decrease, your interest rate remains the same.
Variable interest rate
A variable interest rate consists of a fixed margin and a market interest rate, such as the 3-month EURIBOR for loans in EUR or the National Reference Rate (NRS) for loans in HRK.
Example: VRS = 3M EURIBOR + M = -0.40% + 6% = 5.60%
The advantage of a variable interest rate is that it is usually initially more favourable than a fixed rate, and if market interest rates (EURIBOR, NRS) decrease, the interest rate decreases as well. The disadvantage is that if market interest rates increase, the interest rate will also increases.
Why is a variable interest rate always better at the start than a fixed one?
Because a variable interest rate carries the component of interest rate risk, when you agree to a variable interest rate, the bank transfers that interest rate risk to you. Let’s look at how interest rate risk works in the following two scenarios.
Scenario 1
Loan of 50,000 EUR, repayment period of 5 years, quarterly instalments, direct calculation of interest rate.
Fixed interest rate: 6.00%, while variable interest rate: 3M EURIBOR + 6% (-0.40% + 6% = 5.6%)
Table 1 – Total interest amount per year of repayment
In the initial assessment, it appears that the variable interest rate is more favorable by 573 EUR over the 5-year repayment period. However, is this always the case? Let’s check out the next scenario.
Scenario 2
Loan of 50.000 EUR, repayment term of 5 years, quarterly payments, direct interest rate calculation.
Fixed interest rate: 6.00%, while 3M EURIBOR in 2020 is -0.40%, but it increases to 1.50% at the beginning of 2021. This means that the variable interest rate in 2020 is -0.40% + 6% = 5.60%, while for the period 2021-2025 it is 1.50% + 6% = 7.50%.
Table 2 – Total interest amount per year of repayment.
What happened in Scenario 2? The market interest rate of 3M EURIBOR increased from -0.40% to 1.50%, resulting in a higher variable interest rate compared to the fixed rate. In this scenario, the variable rate is only more favourable than the fixed rate in 2020, while for the remaining period, it is higher. The variable rate in this scenario is more expensive by 1,220 EUR compared to the fixed rate.
The increase of 3M EURIBOR to 1.50% is not unrealistic, as shown in Figure 1.
Figure 1 – Movement of 3M EURIBOR in the period 2000-2019.
Conclusion
The goal of this blog is not to favour either the fixed or variable interest rate, but to provide loan users with information about the risk of interest rate changes. The risk of interest rate changes increases with the length of the loan repayment period, and it should be taken into consideration when deciding on the type of interest rate, especially for long-term loans over 10 years. Let’s be aware that what may seem favourable at the beginning may not necessarily be advantageous in the end. Loan users should be well-informed about all risks, such as interest rate risk or currency risk, in order to make the best decision for themselves at any given time.
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