Fixed Interest Rate: An Overview
A fixed interest rate remains constant for the entire duration of the loan agreement. Unlike floating interest rates, which are tied to a prime rate or underlying index and can fluctuate, fixed interest rates offer stability and predictability.
How to Calculate Fixed Interest Rates
When a loan or bond is priced at a fixed interest rate, the interest expense amount due each period is set and does not change over time. Fixed pricing is more common with bonds and riskier debt instruments lower in the capital structure, rather than senior debt provided by banks.
The primary benefit of a fixed interest rate is the predictability it offers. Borrowers do not need to worry about changing market conditions that could impact the amount of interest due. This stability mitigates the risk of substantial increases in interest expenses.
Borrowers are more likely to choose fixed rates in low interest rate environments to "lock-in" favorable borrowing terms for the long term.
Fixed Interest Rate Formula
The formula for calculating the interest expense on a debt instrument with fixed pricing is straightforward:
Interest Expense=Fixed Interest Rate (%)×Average Debt Balance
Fixed Interest Rate vs. Floating Interest Rate
Floating interest rates fluctuate based on the underlying benchmark rate tied to the debt pricing (e.g., LIBOR, SOFR). The relationship between the market rate and the yield on debt priced at a floating rate is as follows:
Declining Market Rate: If the market rate declines, the borrower benefits from the lower interest rate.
Rising Market Rate: If the market rate rises, the lender benefits from the higher interest rate.
Floating interest rates can be riskier and more uncertain due to unpredictable changes in the underlying benchmark. Conversely, with fixed interest rates, the original interest rate remains constant, eliminating concerns about how much interest will be owed. However, this comes at the cost of not being able to benefit from lower interest rate environments. If the benchmark rate is lower and the lending environment becomes more favorable, the interest expense on a bond priced at a fixed rate will remain unchanged.
Fixed Interest Rate Calculation Example
Let's consider a senior note with a total outstanding balance of $100 million. For simplicity, assume there is no mandatory amortization or cash sweeps (i.e., optional prepayments) across the forecast period.
Senior Notes, Beginning Balance: $100 million
Mandatory Amortization: $0
Cash Sweep: $0
For a variable interest rate, a spread would be added to the market rate (e.g., LIBOR) for each corresponding year. However, in this case, the senior notes are priced at a fixed rate of 8.5%, which remains constant for the entire forecast period. This rate is multiplied by the average between the beginning and ending balance.
Interest Rate, % = 8.5 %
Since the balance of the senior notes does not change throughout the four years, the interest expense stays at $8.5 million every year.
Conclusion
Fixed interest rates provide a predictable and stable borrowing cost, making them an attractive option for borrowers in low-interest-rate environments. They eliminate the uncertainty associated with fluctuating interest rates, though they do come with the trade-off of potentially missing out on more favorable rates in the future.
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