Floating vs Fixed Interest Rate Loans

All loans incur interest, which is how the banks earn money. High interest is bad for borrowers, while low interest is good. However, have you wondered what the difference is between house loans, car loans, or personal loans from an interest rate perspective?

The main difference is in the application of said interest rate.

There are some loans where interest is charged periodically (usually monthly) on however much you still owe the bank. Say this month you owe the bank RM100,000, then interest is charged on this amount. Next month if you only owe the bank RM95,000, then the interest is charged on that RM95,000 smaller amount instead.

In these types of loans, the interest rate can also vary from month to month based on economic factors and policies by the central bank. These types of loans are known as floating rate, because the rate can vary from time to time. The most common example of a floating rate loan is a house loan, also known as a mortgage.

Floating rate loans are ‘fairer’ to an extent, because you are only ever paying interest for the amount outstanding. However, these types of loans usually start at a higher interest rate. Additionally, floating rate loans also run the risk of an increase to loan repayments if the interest rate goes up.

The other type of loan is a fixed rate loan, where an interest rate is set and applied throughout the loan tenure right from the beginning. These usually include car loans called hire purchase as well as personal loans. For example if you are borrowing RM50,000 for five years to buy a car at say, a 4% interest rate: the interest is applied right at the beginning based on the number of years of loan.

RM50,000 x 4% interest x 5 years = RM10,000 total interest

This means your total repayment over five years is RM50,000 initial sum borrowed plus RM10,000 interest, equalling RM60,000. Your loan repayment per month is then RM60,000 divided over 60 months (5 years), equalling RM1,000 per month repayment.

Unfortunately for fixed rate loans, your interest charge is always based on the total sum borrowed. From our example, this is to say the interest you are paying in your 5th year is the same as your 1st year, all based on the RM50,000 original sum borrowed. The advantage of a fixed rate loan on the other hand, is that your repayment amounts are fixed and cannot change. Also, if you are in a low interest rate environment, then any fixed rate loans you take will have ‘locked-in’ the low interest throughout your loan tenure.

At the end of the day loans are costs to us. We should not take them unless absolutely necessary, as we will be paying a lot more for the item we are purchasing. Each type of loan has its pros and cons, so make sure to consider them carefully beforehand.