When you’re looking for a new loan, whether it be a mortgage, student loan, or line of credit, there are two typical types of interest rates you might find: variable vs. fixed interest rate. In some instances, you’ll have the option of choosing which kind of rate you’d like for your loan. It’s important to know how they function and which one might be best for you.
Let’s discover what variable vs fixed rate interest means, examine the advantages and disadvantages of each, and look at some examples of specific loan scenarios, such as variable vs fixed rate mortgages and variable vs fixed rate student loans!
Variable vs fixed rate interest: How they work
First things first…what are these terms, and how do they work? Let’s look at variable rate interest first.
How variable rate interest works
If you have a variable interest rate on your auto loan, your interest rate fluctuates over time because the market for loans changes. As an example, you might be paying 5% one year, 4% the next, and 6% the following year.
A variable interest rate has two components:
The interest margin for a loan is the same as any loan rate. The lender will review your credit score, credit history, and (depending on the type of loan) your debt-to-income ratio. The more positive results you have, the lower your fixed margin of error will be.
Thus, try to obtain a high credit score so that you will pay less on interest.
The component of the interest rate that varies is decided by an index.
The lender chooses which benchmark they’ll utilize for their variable-rate loans. But they don’t control when it goes up or down or by how much. To learn more about federal interest rates, how they change, and when they affect you, read the text below.
As some variable rate loans have an interest rate cap, it prevents your repayments from rising dramatically over time. This protects you from being surprised at a 50% interest rate surprise one year from now.
How fixed rate interest works
Yes, we already had the difficult task out of the way. Take a deep breath – fixed rate interest is exactly what it sounds like! The interest rate remains unchanged over the course of the loan term, without change. For example, 10% for a loan of $100,000 for four years would be $1,000 per year. You begin paying 5% monthly once the loan is started, and you will pay 5% every month until the loan is paid off.
Benchmarks like the prime rate still affect your interest rate when applying for a fixed-rate loan. Lenders consider the current market interest rate in addition to your credit score when determining your rate.
The advantage is that you can rest easy knowing that your test score is locked in no matter what happens in the future. You’re good to go!
Variable vs fixed rates: Pros and cons
Variable and fixed-rate loans both have advantages and disadvantages. Knowing the advantages and drawbacks will help you decide which loan is right for you!
Variable rate pros and cons
Borrowers with variable rate loans have paid less in interest overall than borrowers with fixed rate loans in the past.
This precedent may not hold true in the future, but it’s wise to always remember past results.
If you have a variable rate loan, you take a substantial risk that you will have to pay more if interest rates increase. This makes such loans more of a gamble. The longer you have the loan, the more likely it is that interest rates will increase.
When deciding on a variable-rate loan, it’s vital to inquire about how high the interest rate can go, and how frequently it is subject to change (usually monthly or quarterly).
Variable-rate loans often provide more flexible terms, especially for mortgages. Fixed-rate loans often prohibit breaking your mortgage (which can also make it hard to refinance or sell your home and relocate or pay off your loan early without paying a penalty).
Variable rate loans are typically cheaper and easier to get out of, refinance, or prepay.
If you have a variable interest rate loan, you can’t be sure what your payments will be in upcoming months or years. This can make it challenging to arrange your finances. Your payment could go up or down from month to month or year over year.
Fixed rate pros and cons
You can obviously compare the pros and cons of adjustable and fixed rate loans to ascertain the pros and cons for yourself. Let’s take a look at the details.
With a fixed rate loan, the monthly payment is the amount you pay for the duration of the loan. This means you can budget your cash flow on a monthly basis, making the loan easy to handle. Many people find the lower risk less stressful.
As we have already discussed, studies have shown that individuals with variable rate loans have accrued smaller total interest payments over time, which means individuals with fixed-rate mortgages paid more. This doesn’t mean that the same thing will happen in the future, however!
If interest in variable rate loans rises, individuals with these loans could face huge spikes in payments. If you have a fixed rate loan, you do not have to worry about volatility like that.
You may find that you are getting a lower-rate loan than other people have during periods of high demand.
Fixed-rate loans, such as mortgages, can be difficult and costly to exit or change. This is ideal if you are not certain how long you want it or you want a low interest rate from the outset.
But it is less ideal for people who need something shorter-term and expect they will move, refinance, etc.
Variable vs fixed rate loan examples
Now, let us discuss the various loan types and which type of interest might be best given the historic data and potential risks.
Variable vs fixed home loan
Mortgages are usually the longest loan you’ll ever sign up for — how should this affect your variable vs fixed home loan interest decision? Do you want a consistent, stable payment or one that might change over time? Do you trust interest rates to stay low in the future?
Fixed-rate mortgages are very popular due to their stability and predictability. The most common mortgage term is 30 years, which a lot of homeowners find to be a substantial amount of time where the economy can fluctuate. Choosing a variable interest rate for this loan would be dangerous.
However, there is actually one good argument for selecting a variable rate for your mortgage: it may be better if you don’t plan to remain in the mortgage for a substantially extended time. If you buy a starter home or don’t expect to remain in that location for a lengthy time, a variable-rate loan provides greater flexibility (as we mentioned in the pros and cons section above).
There are also combination mortgages, such as 5/1 Hybrid Adjustable Rate Mortgages (ARMs). In this structure, you have fixed interest for the first five years, then variable interest that changes every year thereafter.
This may provide an appealing option for those planning shorter-term mortgages. In the long run, it has the same risks as any variable interest loan.
Compare your situation to those of other variable and fixed home loan borrowers.
Variable vs fixed rate student loans
When it comes to variable vs. fixed rate student loans, you don’t have much of a choice. Federal student loans are only available with fixed interest, so you’ll get whatever the current federal rates are in the year you receive the loan. You can view the recent federal student loan interest rates on StudentAid.gov.
Federal student loan rates are significantly lower than private loan interest rates. If you’re eligible for federal loans, you should pursue them before you apply for private loans.
If you would like to get a private student loan to cover the cost of your education, you have the option of choosing between variable vs fixed rate student loans.
Going with the variable rate may be a good idea if it is a fair amount lower and you plan on paying it off quickly after graduation. A fixed rate may be preferable if you are taking out a lot of loans and expect it will be a decade or more before they are paid off.
You must also be aware of the other factors to consider when choosing student loans.
Variable vs fixed rate credit cards
Most credit cards have variable interest rates. You don’t usually have a choice with them.
However, the best way to use a credit card is to make a budget and avoid interest. You can do this by paying your bill in full each month. If you don’t owe any money, you don’t pay interest!
Choose what’s best for your finances when deciding variable vs fixed rate!
Ultimately, selecting between a variable vs fixed rate loan depends on your personal goals, expectations, and risk tolerance. Weigh the advantages and disadvantages, make a plan to pay off debt, and move forward based on the option that feels most comfortable to you.
