Variable Rate vs. Fixed Rate Loans Explained
Posted by Frank Gogol in Loans | Updated on May 30, 2023
When taking out a loan, the most important factor is the interest rate. Part of that is what type of interest rate, variable vs fixed rate. Each has different pros and cons. Read on to learn when each type of rate is most appropriate.
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Variable Rate vs. Fixed Rate Loans
All loans have interest rates. The two types of interest rates, variable rate vs fixed rate, are discussed below.
Variable Rate Loans Explained
The interest rate of a variable rate loan changes over time. How these changes happen is outlined below.
How Variable Rate Loans Work
The interest rate on variable-rate loan changes over time. The total interest on the outstanding balance also changes over time. It could increase or decrease. The interest rate is based on a benchmark. One benchmark in the U.S. is the federal funds rate. Another common benchmark rate is the London Interbank Offer Rate (LIBOR). The most common benchmark used for consumer credit products is the prime rate.
The benchmark rate that applies to your loan is specified in your loan agreement. Your interest rate is expressed as the benchmark rate plus a fixed margin. For example, prime+14%.
The margin offered on your variable rate loan depends on many different factors, including the size and length of the loan and your credit score.
Understanding Interest Rate Caps
Rarely, the benchmark reaches levels that make the loan impractical. If the benchmark rate on your loan rises very high, it could become impossible to pay it off in a reasonable time.
To prevent this, many variable rate loan agreements limit the maximum possible interest you could be charged. These limits are called interest rate caps.
Fixed Rate Loans Explained
The interest rate of a fixed-rate loan stays the same throughout the life of the loan. That means the interest charged on your outstanding balance will always be calculated based on the same percentage.
The decision between a fixed and variable rate loan depends on many different factors. One of the main benefits of a fixed-rate loan is stability. You know exactly how much you will be paying for the loan, regardless of what happens in the economy.
What’s the Difference?
The difference between a fixed and variable rate loan is how the interest you owe is calculated. For a fixed-rate loan, the interest is always calculated at the same rate for the life of the loan. For a variable rate loan, the percentage interest depends on external economic factors, which take the form of a benchmark rate.
How and When to Choose Variable or Fixed Rate Loans
The decision between a variable rate and a fixed rate loan depends on many factors. The main benefits of each type for different loans are outlined below to help you decide.
Personal Loans
The interest rates on personal loans tend to be higher than other types of loans. This is because personal loans are usually unsecured. Keep this in mind when deciding between a fixed or a variable rate. The benefit of a fixed rate in this case is that your repayments will be predictable.
A variable rate offers the possibility of a decrease in your payments in the future if the benchmark rate decreases. However, this also comes with the risk of an increase in the benchmark rate.
If your income is high enough that you can easily afford the personal loan, the risk might be worth it. If it is already a strain on your finances, then it is better to avoid the risk and opt for a fixed rate.
Student Loans
If you are eligible for federal student loans, which are only offered at a fixed rate, that option is a good idea. This is especially true if you have a low credit score or no credit history. This is because the government charges a set, fixed interest rate on federal student loans. The rate doesn’t change based on your financial situation.
Mortgages
Mortgages have a long life, often 30 years, so your choices will have lasting implications on your finances. In economic conditions where benchmark rates are low, it makes sense to lock in that low rate for the life of your loan using a fixed interest rate.
On the other hand, if benchmark rates are high, there is the possibility of a decrease in the future. Alternatively, you could refinance or switch later to a fixed rate as economic conditions improve.
Whatever you decide, it is important to keep in mind that even a fraction of a percentage point of difference in interest, when stretched over decades, and on a loan as large as a mortgage, could amount to thousands of dollars in extra interest payments or savings.
Variable Rate vs. Fixed Rate Loans FAQ
The questions answered below often come up when discussing variable rate vs fixed rate loans.
Is a Variable or Fixed Rate Better?
Like tools, each is useful for different things. Whether a hammer or screwdriver is better depends on whether you are making something with screws or nails.
Similarly, a fixed rate is better if you have a long loan that you can get a low rate on. This results in predictable payments over the life of the loan.
A variable rate loan is useful when benchmark rates are high but expected to decrease over time, thus making the loan cheaper. It is important to only choose this option if you know you will still be able to afford it if the benchmark rate increases instead.
Defaulting because of a rate adjustment is still defaulting and will be treated the same by your lender.
Is a Variable or Fixed Rate Lower?
Variable rates depend on changes in the benchmark rate. Generally, benchmark rates are higher during times of economic prosperity, and lower during economic slow-downs. Whether a given fixed rate or a variable rate is higher depends on macroeconomic conditions at that time.
Do Variable Rates Ever Go Down?
Yes. A variable rate is linked to an external economic indicator such as the prime rate, LIBOR, or federal reserve rate. These rates increase or decrease depending on national and global economic conditions.
Can I Switch from a Variable Rate to Fixed Rate?
Usually. Many lenders allow you to switch from a variable to a fixed rate on your loan whenever you want to. However, there is almost always a fee associated with making that change.
It is unusual for lenders to allow for a change from a fixed to a variable rate. Whether you can make these changes and how much it will cost is laid out in your loan agreement.
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Final Thoughts
The decision between variable vs fixed rate depends on your financial goals and situation. Variable rates change over time-based on economic benchmarks, and fixed rates stay the same for the life of the loan. Variable-rate loans risk getting more expensive over time, but if the benchmark decreases, your loan can get cheaper over time. A fixed rate allows you to know exactly how much your payments will be for the life of the loan.
