How to Choose Between Floating and Fixed Interest Rates

Understanding Floating and Fixed Rates

SyntheticFi loans come in two flavors:

Floating (Variable) Rate: An open line-of-credit with interest due monthly.

• The interest rate is adjusted every month based on market conditions, reflected through changes in the SOFR benchmark.

• The borrower can pay down the loan or borrow more at any time.

• Unpaid interest can accrue, and there's no preset term to fully repay the loan. The loan can remain outstanding indefinitely, so long as the portfolio collateral meets the lender's maintenance requirements.

• For a deeper dive into floating rates, refer to this article.

Fixed Rate: Similar to a fixed-rate zero-coupon bond, the borrower locks an interest rate that remains constant, guaranteeing predictable costs.

• The expiration of the loan is fixed, ranging from 3 months to 5 years. 

• Both the principal and the total interest must be paid at the end of the term. However, the principal amount due could be refinanced with a subsequent loan, effectively making the loan interest-only.

• For a deeper dive into fixed rates, refer to this article.

SyntheticFi offers clients loans with floating rates and fixed rates, and anywhere in between. Schedule a time for a tailored proposal here.

Floating vs Fixed Rates in Practice

Let's walk through a few scenarios to understand the trade-offs between fixed-rate and floating-rate loans.

Example - Comparing Floating vs Fixed for a Long Loan Term with Predictable Costs

Suppose Tony is looking to buy a $1MM property in Menlo Park. He's worked at Apple for the last 7 years, and through a combination of employer stock grants and wise investment decisions, he's grown a portfolio worth $3MM. Through SyntheticFi, Tony finances the purchase of the property by taking out a $1MM loan—with no down payment. Let's compare the fixed-rate and floating-rate options: 

	Floating-Rate	Fixed-Rate
Example	5% floating-rate	4% fixed-rate, 5-year fixed-term
Rate Structure	If Tony chooses to make interest-only payments for 5 years, he would pay $4,166.67 per month.  During the 5 years, he would pay $250K in total interest, assuming the interest rate remains constant.	Over the course of 5 years, Tony doesn't pay down any of the principal or interest.  At maturity, Tony makes a lump sum repayment that covers the $1MM principal and total interest of $200K.
Rate Fluctuations	If the interest rate becomes 6% after two years, Tony would pay $5K in interest monthly, and $60K annually. If the rates remain steady at 6%, then over 5 years, Tony would pay $280K ($50K × 2 + $60K × 3) in overall interest.  If instead the rate dropped to 2% after year two, then Tony would start paying $1,666.67 per month, and the sum of his interest charges would be $160K ($50K × 2 + $20K × 3) after 5 years.  The uncertainty about future rates may complicate budgeting. For safety, Tony would need to maintain a financial buffer when rate fluctuations are unfavorable.	By locking in 4%, Tony is protected if interest rates rise (e.g. to 6% due to Fed rate hikes), avoiding a higher interest payment. However, if rates drop, he misses potential savings.  The fixed 4% rate allows Tony to predict his exact costs, simplifying budgeting and planning.
Term Flexibility	The line-of-credit nature of the floating-rate loan allows Tony to repay whenever he chooses, with any additional fees.	If Tony wants to take advantage of more favorable interest rates mid-way through the loan term, he could close the loan out early and initiate a new loan. However, Tony would incur an interest rate differential as a result.

(Here are the latest rate quotes.)

Example - Comparing Floating vs Fixed for a Short Loan Term with Uncertain Costs

Fixed-rate loans with fixed terms are ideal for borrowers looking for predictability over longer time horizons. Floating rates, on the other hand, are suited for shorter-term needs, where clients can expect less volatility in interest rates, or when clients need flexibility in paying down the principal soon, in the next 6-12 months.

Suppose instead, what Tony needs is a bridge loan to purchase and renovate the $1MM property in Menlo Park, which he plans to flip within 6 months.

	Floating-Rate	Fixed-Rate
Example	5% floating-rate	4% fixed-rate, 6-month fixed-term
Rate Structure	If Tony chose to make interest-only payments, he would pay $4,166.67 per month. After 6 months, his interest costs would sum to $25K, assuming the interest rate remains constant.	By loan maturity, Tony has resold the property so he can repay the $1MM principal and his total interest charges would be $20K.
Rate Fluctuations	Tony is vulnerable to interest rate changes but because his timeframe for the loan is short, the fluctuations are unlikely to be significant, and neither will they impact Tony for very long. This affords some certainty in budgeting and planning.	Once again, Tony is protected from updates to interest rates, affording predictability in final costs.
Term Flexibility	The draw-as-needed loan structure matches the unpredictable liquidity in a flip. So Tony has freedom to pay down the loan whenever his cash flow permits.	Shifts in Tony's timeline can be problematic. If there are, say, delays in renovations, and Tony can't sell the property in 6 months, then Tony would have to roll the balance forward into another loan at expiration. If the property sells in 4 months and he repays early, then he might face an early payment fee.

How to Make a Decision

Technically speaking, SyntheticFi's floating rate and fixed rate loans are mathematically equivalent. Even though the initial interest rates differ, the two types of loans have priced in the future rate movements, so you can't go wrong choosing either option.

When rate cuts by the Fed are expected, a common misconception is that borrowing with floating rates is a better choice, even if the initial rates are higher than fixed rates. However, markets tend to be efficient in this respect, pricing longer-term rate cuts into the current interest prices. Therefore, if expectations about the market turn out to be accurate, then the borrowing cost between floating and fixed rate loans becomes roughly equal. To learn more about how these interest rates are determined, read our article about how SyntheticFi loans work.

As the previous example illustrates, the decision for better loan structure depends on the use case, rather than advertised interest rates.

Time Horizon and Predictability

If the client is borrowing for a longer period (e.g. Tony’s 5-year property purchase), a fixed-rate loan offers predictability. Interest charges are known upfront, which makes financial planning easier. Here are some borrowing scenarios where fixed-rate may be a better option for clients: 

• Real estate: Buying a property (primary residence, second home, investment property, etc.) often comes with long-term commitments, whether your client is borrowing to put cash down or purchasing with cash outright. SyntheticFi's fixed-rate loans protect against interest rate fluctuations from market volatility, so you can confidently budget the borrowing expenses.

• Private investments: Investments in private equity, venture capital, etc. have lockup periods that last for an established number of years. Clients can secure a SyntheticFi fixed-rate loan with a term that matches the commitment period, e.g. a client can borrow $2MM at 4%-fixed for a 5-year term to commit to a private equity fund which anticipates a net 12% annual return—enough to cover the known interest costs at loan maturity.

• Cash management: Clients who choose a fixed-rate loan will defer interest payments to the end of the term. This is useful for business owners and clients who might have volatile cash flow in the interim, or who want to preserve their cash flow to reinvest in their enterprises. 

• Deferred cash flow: If a client expects to receive substantial, predictable cash flow (e.g. an annual bonus), then with a fixed-rate loan, they can repay the fixed principal and interest as a lump sum when closing out the loan.

Flexibility and Liquidity

Floating-rate loans function like lines of credit, allowing clients to draw funds as needed and repay them whenever they choose. This is particularly useful for borrowers with variable cash flow or short-term liquidity needs.

• Bridge loan: The flexibility of floating-rate loans aligns well with the temporary nature of bridge financing, where clients can't commit to an exact repayment timeline. Borrowing to purchase and renovate a property for a quick resale, meeting urgent capital calls and repaying when funds are available, or covering a large tax bill and repaying when cash flow allows—these are all cases that benefit from freedom of repayment.

  • When there's some certainty about the repayment timeline, the client can take advantage of fixed-rate terms for a period of time, and then refinance with a floating-rate loan, e.g. if Tony knows he'll need at least 6 months before he can flip a property, he can start with a fixed-rate loan with a 6-month term and then convert to a floating-rate loan afterwards.

• Debt consolidation: With loans like HELOC, which typically have floating rates, the client has the flexibility to consolidate that under a single floating rate loan.

• Diversification: Portfolios that are concentrated in one or a few assets require a gradual and dynamic process of rebalancing. This is common among corporate employees compensated with stock, who amass concentrated positions in their company stock from regular grants and vesting. Investments can be diversified with borrowed funds, and when the portfolio is adjusted with sufficient cash flow, the loan can be repaid. Given floating-rate loans are structured as lines of credit, borrowers can draw and repay as needed to achieve optimal diversification, avoiding the rigidity of fixed-rate terms. 

• Margin Investing: Clients can borrow against their securities to purchase additional securities. This leveraged exposure prioritizes returns over payment certainty, as borrowers expect gains to cover interest and principal. The level of risk involved is compatible with a floating-rate borrowing strategy, where funds can be flexibly accessed and repaid to maximize returns.

• Lifestyle purchases: A floating-rate loan can serve as a line of credit, making it functionally similar to a credit card. The borrowed funds can be spent on non-essential items and experiences, e.g. a vehicle purchase or luxury vacation.

Loan Repayment

As we've mentioned, borrowing with a floating-rate loan is just like using a line of credit. Repayments are straightforward and flexible. Clients seeking the same flexibility with the certainty of fixed-rate borrowing can use the following strategies:

• Saving: Clients can pay off a fixed-rate loan like a mortgage with regular payments by using those payments to build a capital buffer, e.g setting up a savings habit to buy treasuries, which would offset much of the interest charged on the principal.  

  Suppose Tony takes out a 5-year $1MM loan against a $2MM portfolio via SyntheticFi to buy a house. After the first year, he can put back $200K in treasuries. Even though he's not "paying off" the loan, he's 1) earning a pretty high yield on the treasuries, and 2) creating a larger "buffer" against his margin. Originally, he was borrowing 50% against his portfolio; now he's only borrowing $1MM/2.2MM = ~45% of his portfolio.

  
  

• Laddering: SyntheticFi offers a “laddered” approach, similar to a bond ladder. For example, a client can ladder SyntheticFi fixed-rate loans, with expirations ranging from one to five years, each 20% of the total loan value, enabling a 20% annual paydown.

• Rolling: Clients, e.g. entrepreneurs with unpredictable cash flow, can continually refinance fixed-term loans. When one loan ends, they can repay the interest and roll the principal into a fresh fixed-rate loan, or they can choose to combine the principal and interest into the new loan.

Taxes

As a final note, the tax treatment of interest expenses on fixed-rate and floating-rate loans is the same: deductible as capital loss, regardless of the purpose of the loan. See our article about the tax benefits of SyntheticFi loans.

Final Thoughts

In theory, fixed and floating-rate loans should yield similar economic outcomes if market expectations about interest rates remain unchanged, as markets efficiently price in anticipated rate movements, like SOFR or fed funds rate shifts, into fixed rates. However, practical differences arise due to the certainty and flexibility each option offers. To make the best decision, clients should select the longest loan term they are comfortable locking in, balancing the predictability of fixed rates against the adaptability of floating rates. For long-term stability, a fixed-rate loan ensures consistent payments, ideal for predictable budgeting, as seen in Tony’s 5-year property purchase. For short-term needs, like his 6-month bridge loan, a floating-rate loan’s flexibility and lower initial costs can be advantageous. By considering the time horizon, liquidity needs, and confidence in rate forecasts, you can choose the option that best fits your client's financial strategy.