Choosing Fixed or floating interest rates?

This is a question that is constantly emerging, and it is whether one should choose fixed or floating interest rates. However, there is no correct answer.

Looking at the past ten years, choosing a fixed interest rate has become a more relevant alternative. Many loan providers now operate at fixed interest rates in addition to ordinary floating rate loans. Just to fix it: Fixed interest rate means that the interest rate does not change until the maturity period is over.

The most common bonding periods are 3, 5 and 10 years

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In other words, you can be both lucky and unlucky in such a choice. If the general interest rate level goes up, it is clear that it is beneficial to have chosen a fixed interest rate agreement. But if the interest rate level goes down, it will of course be the other way around.

Therefore, there is also almost a 50/50 chance of earning or losing on fixed-rate loans versus floating interest rates. Many believe that fixed interest rates should be viewed more as insurance. If any rising floating interest rate will cause problems in your finances, it may be a wise choice to tie the interest rate on all or part of the loan. We will return to this in more detail.

Predicting interest rates in the future is very difficult

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But first, it is important that you have an understanding of how the fixed interest rate is set.

To understand fixed-rate loans, it is necessary to understand how banks determine their interest rates. The bank borrows money by issuing bonds with a fixed maturity at a fixed interest rate. The borrower must therefore tie up his interest income for the same period as the borrower fixes his interest expenses. The bond buyer will have paid for the risk he takes when tying his interest income.

In particular, three conditions are important for a buyer of bonds:

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1. Risk of failure. Expected developments in inflation and short-term interest rates, which in turn affect long-term interest rates, are of great importance to anyone who places their money in bonds. Since he fixes an interest rate, it must be high enough so that the floating interest rate does not rise so much in the meantime that this would have been a better business for him.

2. The buyer assumes a credit risk when investing in private bonds: If the bank that has issued the bond receives payment problems, the bond will decline in value.

3. The buyer requires a liquidity premium when he puts his money into a bond. After all, he doesn’t get his money back for the bond maturing, for example in ten years. (The buyer can sell the bond at any time, but then he is exposed to fluctuations in the value of the bond. To be sure that La paid the agreed interest plus the deposit, he has to sit with the bond for the entire term.) that the bond buyer requires a risk premium, and this is higher the longer the bond period. The risk premium is what you want fixed interest loans to pay.
Since you choose to pay this premium, it must mean that you believe it is likely that the floating interest rate will rise above this level. In other words, you must consider that the investor’s risk premium is too low; that he is not getting paid enough to tie the interest rate to you. We believe professional investors who monitor the fixed income market daily demand a high enough risk premium.

 

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