It’s not the zombie at your door that’s sending chills up your spine. It’s your auto loan payment. As dusk settles on your neighborhood, a shrill wail shatters the evening’s peace. Goosebumps rise along your arms as you hurry your way inside, closing and locking your door behind you.…
If you want to take out a loan, you can choose from a variable rate or fixed rate. But which is better?
A loan can help you cover the cost of your car, house, education, and just about anything else. But before you commit to one, you’ll have to decide whether you’d like a variable rate or fixed rate.
The answer to this question will depend on several factors like your budget, emergency fund, creditworthiness, risk tolerance, and term of the loan. Let’s dive deeper into the difference between a variable rate loan and fixed rate loan so you can make an informed decision.
What Is a Fixed Interest Rate Loan?
If you choose a loan with a fixed interest rate, your rate (and monthly payments) will remain the same during its entire term. You’ll lock in the rate when you sign your loan agreement and it won’t change with fluctuations in the market.
With a fixed interest rate loan, the cost of borrowing money will remain constant throughout its life. The better your credit score and finances, the lower fixed interest rate you’re likely to receive.
Pros and cons of a fixed interest rate loan
The most noteworthy benefit of a fixed interest rate loan is its predictability. You’ll have the same interest rate from the moment you take out the loan until your term comes to an end. This can allow you to plan and budget for your loan payments in advance. Since you won’t have to worry about your rates rising, you’ll know exactly how much you’ll owe each month.
While a fixed interest rate loan will give the peace of mind that your rates and payments will never change, it may cost you more in the long run. Compared to variable rate loans, fixed rate loans are often more expensive. A fixed rate loan may be hundreds or even thousands of extra dollars.
What Is a Variable Interest Rate Loan?
With a variable interest rate loan, your rate will change over time in response to market conditions. When interest rates rise, you may find that your rate, monthly payment, and total repayment costs increase as well. Unlike a fixed interest loan, the initial interest rate or rate you secure at first won’t be the same throughout the life of the loan.
You can get a variable interest loan on mortgages, home equity lines of credit, credit cards, and student loans. Adjustable rate mortgages are unique because they lock in your starting rate for a certain period of time and then transition to a variable rate. With credit cards and private student loans, however, the rate and monthly can change immediately.
A variable rate consists of an index and a margin. Since it’s based on economic conditions, the index rate will vary over time. The margin, on the other hand, will depend on your credit score and be locked in when you get approved. It won’t change until you pay off your loan.
While there’s no way to know whether, when, or how much variable interest rates will change, they usually do increase at some point. If you take out a variable interest rate, expect that it probably won’t stay the same.
Pros and cons of a variable interest rate loan
The greatest benefit of a variable interest rate loan is that you may pay less over the long-term. Studies have shown that while they may not be the best choice for all borrowers, variable interest rate loans are usually less expensive than fixed interest rate loans. If you go this route, you may land a lower rate at first and even watch your rate decrease.
On the flip side, rate increases are a possibility with variable interest rate loans. A higher rate will cause your monthly payment to go up and may take a serious toll on your budget. You won’t have any certainty about how much you’ll pay in interest over time because your rate can and will likely change.
What Types of Loans Offer Variable and Fixed Rates?
While some loans come with variable interest rates, others offer fixed interest rates. Here’s a look at the various types of loans you may consider and the types of interest rates you can expect.
In most cases, auto loans have fixed interest rates so you can calculate exactly how much you’ll pay for your car. While they may exist, auto loans with variable interest rates are rare. Variable rates are usually only seen at specialized lenders and banks in other countries.
Banks, credit unions, and other financial institutions offer both fixed rate and variable rate mortgages. A variable rate mortgage or adjustable-rate mortgage will usually start with a lower interest rate than a fixed rate mortgage. This rate will likely increase after several months, a year, or a few years.
Fixed rate personal loans can help you secure an affordable monthly payment on a longer repayment period. But variable personal loans may be a more affordable way to quickly pay off debt. The higher your credit score, the better rate you’re likely to secure on a personal loan.
Student loan interest rates depend on the types of student loans you choose. Federal student loans only offer fixed interest rates. If you opt for private student loans or refinance, variable rates loans may be an option.
Generally speaking, credit cards have variable interest rates. Even though variable interest rate credit cards tend to be the most common, there are cards with fixed interest rates. Since interest rates on credit cards are usually unpredictable, it’s important to pay off your cards in full and on time every month to avoid debt.
Home equity lines of credit (HELOCs) and home equity loans
HELOCs work a lot like credit cards and allow you to borrow as much or as little as you’d like up to a set credit limit. Just like credit cards, their interest rates are generally variable. Home equity loans, on the other hand offer a lump set of money and come with fixed interest rates.
How Are Variable and Fixed Rates Determined?
Variable rates are typically based on changes to the London Interbank Offered or LIBOR rate or the federal funds rate. They may also be associated with a benchmark rate like the prime rate. It depends on the type of variable interest rate loan you select. Fortunately, most variable rate loans come with caps or maximum limits on interest rates.
Fixed rates loans aren’t directly linked to the interest rate environment as private lenders set them. Factors like your loan amount, repayment term, credit score, finances, and whether you have a cosigner will all play a role on your interest rate. If you have good credit and steady income, for example, your rate will be lower than someone with bad credit and inconsistent income.
What To Consider When You Shop for a Loan
When you shop around for a loan and explore all your options, there are a number of questions you should consider. Your answers to them will help you determine whether to take out a variable interest rate loan or a fixed interest rate loan. Here are a few examples of questions to ask yourself.
- What type of loan do I want? While you may choose a variable rate for a private student loan, you may steer away from it or not be able to get one for a mortgage or car loan. Think about the type of loan you’d like and what types of interest rates it offers.
- Am I comfortable with interest rate changes? You may be okay with the interest rate changes and lower or higher loan payments that come with variable interest rate loans. Or you might feel better with the stability and predictability of fixed interest rate loans. Your personality and financial situation will dictate this answer.
- What loan term do you prefer? If you’d like a longer loan term and go with a variable rate loan, you’ll need to accommodate market fluctuations for longer. In this scenario, you may find that a fixed rate loan is the better choice. A variable rate loan will likely be easier on your budget if it has a shorter term.
Variable Interest Loan vs. Fixed Interest Loan: Which Is Better?
So, how do you know the best option for you? There’s no hard and fast answer. It all depends on your unique situation. If you don’t like surprises and want to know exactly what your monthly payments will be, you may be better off with a fixed rate loan. It can eliminate the risk of interest rate changes over time.
On the other hand, a variable rate loan may make sense if you’d like to save as much money as possible over the life of your loan. It can also be a good option if you have the flexibility to make higher monthly payments in the event interest rates do increase. Additionally, you may benefit from a variable rate if you want a short-term loan or plan to pay off your loan fairly quickly.
No matter which option you choose, be sure to read your loan repayment plan carefully before you sign on the dotted line. If you have any questions or need clarity, don’t hesitate to contact your lender.