Personal finance takes on many forms but primarily it concerns the interest rate. This interest is actually the “fee” that we pay for using the lender’s money when we avail of personal finance loans. This is of interest (pardon the pun) or concern to us since the rate of interest determines how “costly” the money is – the cost of borrowing. Generally, it is good to borrow when rates are low and eschew borrowing when high rates prevail in the market. But there are rare instances when borrowing is also advantageous such as during high inflation regimes when the cost of repayment becomes cheaper because money has “depreciated”. High inflation makes the borrowed money “obsolete” since we repay the loan in depreciated currency. It simply means that money now has less purchasing power than before.
Conversely, it makes sense to lend your excess money when the interest rate is high. This indirect “lending” on your part involves the amounts you sock away into your savings account which the bank as a financial intermediary lends out to its borrowing clients. In a normal economic environment, interest rates should be higher than inflation rates. This higher interest regime compensates for the loss of purchasing power due to ordinary inflation. In extreme cases such as during hyper-inflation, these rules and assumptions do not apply.
- Fixed Rates
Personal loans that have fixed rates are called fixed-interest loans. Fixing of interest rates are usually done on annual review and the rate stays fixed for the next 12 months. This is advantageous for the borrower since monthly payments (amortizations or installments) can be budgeted with a degree of certainty. In an age of sometimes unpredictable financial markets, lenders such as banks and credit unions rarely agree to a rate fixing of more than 12 months. A new client borrower, however, can fix interest rates for up to 5 years.
- Variable Rates
Variable loan rates indicate that these consumer loans such as a housing loan or a car loan have rates adjusted more frequently than a fixed interest loan. Most loans, especially in today’s volatile markets, are variable-rate loans which are adjusted quarterly or even monthly. This allows the lender to reflect the latest cost of funds (interest rates it had paid to source those funds) on loan pricing in a more equitable manner. When marginal cost rates go up, these lenders have no choice but to raise their interest rates as well. However, when rates go down, they are likewise obliged to reflect lower rates in loans.
- Adjustable Rates
This is the most common type of loan where interest rates are adjusted at certain designated times of the loan. The common term for this loan type is adjustable rate mortgage (ARM) and is widely popular especially among U.S. borrowers. This should be differentiated from variable-rate loans which are adjusted much more frequently (as frequent as monthly). ARM loans are normally adjusted either semi-annually or annually. An important feature of ARM is an option that allows the borrower to have his loan converted into a fixed-rate loan. This feature is attractive to borrowers who anticipate a period of rising interest rates. They can lock their loans into a lower interest rate before rates start rising. However, most banks no longer allow you to revert back to an adjustable rate mortgage if this option is exercised. This convertible feature should be availed only when a borrower is certain as to which way interest rates are going for the foreseeable future. It should be exercised with caution and foresight. A very good site to learn more about the pitfalls of ARMs:
http://www.federalreserve.gov/pubs/arms/arms_english.htm#paymentshock
- Balloon Payments
This is a type of mortgage that does not fully amortize or is not fully paid at the end of the loan term. It simply means a balance of the principal amount remains after making all those required amortizations for the loan. This is called a “balloon payment” mortgage (sometimes erroneously referred to as a “bullet payment” mortgage) because the last payment is a lump-sum payment that is considerably larger than the previous smaller monthly amortizations. “Bullet payment” loans are slightly different in that they require just a single payment at loan maturity for the whole loan amount. Some borrowers prefer this loan type since the first amortizations will be lower and therefore easier for them initially. They hope to pay off the entire remaining loan balance when their finances or business will have significantly improved over the life of the loan. This arrangement is mutually beneficial too.
This is very common in commercial real estate where realty values go up during the loan period and the property has appreciated considerably by loan maturity. Commercial loan borrowers then use these higher property values to get a new loan to refinance the old loan. The new loan granted is now a fully-amortizing loan. A balloon payment mortgage is typically not allowed for housing or residential mortgages because homeowners might have difficulty getting the loan re-financed and could possibly face foreclosure. Most countries that have balloon payment mortgages make it mandatory for banks to automatically give the home loan borrower a new loan to refinance the remaining loan balance to avert foreclosures and evictions.