Which is a Better Option for You: Fixed Rate Loans vs. Variable Interest Loans

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Category: Loans
Posted on: 03/23/2021
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Deciding between a fixed-rate loan or a variable interest rate loan can have differing impacts on your financial future. Each loan type has its own sets of advantages and disadvantages, and you won't want to dive into a lending solution without knowing them.

You'll find that fixed rate and variable rate loans are strikingly different in their main characteristic: the rate. For a fixed-rate loan, the rate won't change, offering predictability and security in payments. A variable rate loan can fluctuate over time, so borrowers could enjoy its decreases but also be hit with its increases.

Remember: when deciding which type of loan is right for you, always do your research first, so you choose the one that fits best for your financial profile.

Defining a Fixed Rate Loan

Fixed-rate loans have interest rates that remain the same for the loan's lifetime. No matter the market fluctuations, the borrower pays the agreed-upon, standard monthly payment until the loan is paid off.

What is a Fixed Rate Loan Good For?

Borrowers opt for fixed-rate loans for things like their mortgages, car loans, or personal loans. These are all large investments that require a long-term loan to pay off, and a fixed rate can help guarantee stability and security with their finances. Fixed rates allow for budgeting and planning for large purchases like a house, which is considered the biggest investment a person will make in their lifetime.

Defining a Variable Rate Loan

A variable rate loan has an interest rate that responds to changes in the market. These particular loans tend to have lower interest rates because of their risk. Borrowers are taking a chance when they choose a variable rate loan. They can ride the market for a beneficial decrease in interest rates or suffer the consequences when interest rates rise, subsequently increasing the cost of borrowing.

Any borrower thinking about a variable rate loan should understand the risks before making the commitment. Borrowers choose variable rate loans if they're able to pay off the loan fairly quickly to avoid any interest rate hikes and if they can afford to take the risk.

How Do Variable Rate Loans Work?

Because variable rate loans are more complex than their fixed-rate loan counterparts, there's more to understand how they work. These types of loans are tethered to one of two benchmark rates: the London Interbank Offered Rate (LIBOR) or the Prime Rate. These two rates act as baselines for lenders issuing variable rate loans, who then add their own margin to calculate their borrower's final rate.

The interest rate in a variable rate loan also relies on the borrower's credit score and creditworthiness. Other factors include the lending companies themselves, as they all differ in their underwriting methods and the loan product. An example of how an interest rate is decided for a variable rate loan is a Prime Rate of 4.25%, and added margin from the lender of 7%-20%, and the borrower with a good credit score with a 10% margin added. In the end, the borrower might receive an interest rate of 14.25%.

It might seem as if the lenders and the market call all of the shots in a variable rate loan. That's not necessarily the case. Borrowers are protected if these benchmark rates spike to extremely high levels, and caps can prevent borrowers from being slammed too hard. The caps, however, are also set at high levels too.

What Type of Loans Have Variable Rates?

Many options you'll see for fixed-rate loans are also available instead with a variable rate. The market is risky, even with ceilings on interest rates that can protect borrowers if the baseline rates spike to high levels. For many types of loans, borrowers can benefit despite this depending on the term length and what the loan is used for.

A popular option for variable rate loans is a 5/1 adjustable-rate mortgage. It has a fixed rate for five years but then adjusts every year after that period. And if rates go down, you'd save money. Studies have shown that borrowers are more likely to pay less interest overall with a variable rate loan over time than a fixed-rate loan.

Fixed-Rate or Variable Rate?

Your personal financial situation is unique, so if you're wondering if a variable rate or a fixed-rate loan is better, the answer is dependent on what suits your needs the best. Long story short: you'll have to do the math. Do you prefer stable payments, or can you afford to take the risk?

If you're not sure, consider these types of common loans and see if a fixed or variable rate will work out better in your favor:

Student loans: choose a fixed loan if you have very little credit history or a poor credit score. Many students and recent grads are just starting out, and if this describes you, a fixed rate can be the better option. Typically, the majority of students finance their loans with federal loans, which only have fixed rates. While variable loans are available for students choosing between federal and private loans (and those with good credit can often get a lower interest rate with a variable rate loan), a fixed rate is essential for young adults looking to maintain a budget for the early days of their careers.

Mortgages: as stated previously, many borrowers choose a fixed rate for their mortgages. A variable rate, for most homeowners, is simply too risky, especially considering the long term-lengths and sizable loans that define most mortgages.

Personal Loans: long-term personal loans, like mortgages, usually work best for most borrowers under a fixed-rate loan. Reliable, predictable payments across a long-term payback period can keep borrowers on track for their budget and personal finances.

Short-term personal loans can work well and save you money with a variable rate (if the market is in your favor). You'll pay off your loan quickly no matter what, and if you can afford to take the risk of potentially increasing rates, it shouldn't affect you too much. And if the rates dip, you'll have the opportunity to come out ahead.

Which to Choose?

There's no set answer because of the many factors that go into a loan. Your financial situation is unique, so you'll have to do some calculations before you jump into either type of loan. Consider elements like debt-to-income ratio, your credit score, the lender you're choosing for your loan, your own financial situation, the loan's amount, and the term-length.

Variable-rate pros:

  • Rates will usually start out lower than fixed rates
  • If variable rates don't rise or even lower, you could save money on interest

Variable-rate cons:

  • Monthly payments are unpredictable and can affect your budgeting
  • Market trends can cause the variable to increase

Fixed-rate pros:

  • Your rate stays the same no matter the market trends
  • Your monthly payments also remain the same

Fixed-rate cons:

  • Rates are usually higher than those for variable rate loans
  • If the market trends towards lower interest rates, you'll miss out on savings

The bottom line is: for predictable payments, a fixed loan could be for you. For the chance to save on interest if you can afford the risk, consider a variable rate loan.

Finance Guru

Finance Guru