Taking out a loan is nerve-wracking enough without having to decide whether a fixed or variable interest rate is better suited for your needs. On one hand, a fixed rate provides certainty and stability by locking in a set interest rate for the full term. On the other, a variable rate offers lower initial payments and potential savings if rates trend down over time. So how do you decide? By understanding the fundamental differences between the two and weighing the pros and cons as they relate to your unique financial situation.
This article will clearly outline the defining features of fixed and variable rate loans, analyze the potential benefits and drawbacks of each, and provide key factors to consider when determining which option makes the most financial sense based on your individual lending needs and risk tolerance.
One of the biggest decisions to make when taking out a personal loan or mortgage is whether to opt for a fixed or variable interest rate. While a fixed rate remains constant over the full repayment term, a variable rate fluctuates along with changes in the market. The type of loan you choose determines how much your regular payments will be and how much interest you’ll ultimately pay over the lifetime of the loan.
To pick the right loan option for your situation, you need to understand the key differences between fixed and variable rate loans. While the lower initial payments of a variable rate loan may be tempting, a change in interest rates could significantly impact affordability down the road. Alternatively, the stable payments of a fixed rate remove uncertainty and make it easier to budget, though you may miss out on savings if rates decline.
This article will outline everything you need to know to decide between a fixed or variable rate, including:
- Defining features of fixed and variable rate loans
- Pros and cons of each type of loan
- An analysis of which option carries more risk
- Key deciding factors based on your financial profile
- Questions to ask your lender
Arm yourself with the information below so you can make an informed, confident decision on which lending option best suits your needs and current financial situation.
Understanding the Difference Between Fixed and Variable Rate Loans
All loans charge interest on the amount borrowed. This interest rate is expressed as an annual percentage rate (APR) that determines the actual cost to the borrower. Loans fall into two categories – fixed rate or variable rate – depending on whether the interest rate remains unchanged or fluctuates over the repayment period.
What are Fixed-Rate Loans?
A fixed-rate loan keeps the interest rate constant over the full term of the loan, typically ranging from one to 30 years. Your principal and interest payment will remain the same each month, providing reliable predictability to simplify budgeting.
Most common fixed-rate loans include:
- Mortgages
- Auto loans
- Personal loans
Since the interest rate won’t change, your regular payment is locked in for the duration of the loan. This allows you to accurately calculate the total repayment costs. Assuming the initial rate is competitive, a fixed loan shields you from increases if market rates trend up due to inflation or other economic forces.
The only way your payment changes is if you make additional principal payments to pay the loan off faster. Otherwise, you’ll make the same payment until the loan is fully repaid.
How Fixed Rates Are Determined
Lenders set fixed interest rates based on a benchmark rate at the time of origination – typically tied to the prime rate or yields on U.S. Treasury securities – plus a markup that factors in perceived credit risk and profit margin. This means that fixed rates reflect economic conditions when the loan was taken out.
As a result, if market interest rates decrease significantly, your loan rate may seem comparatively high since it won’t change. However, you’re protected on the flip side if prevailing rates increase later on.
What are Variable-Rate Loans?
Unlike fixed-rate loans, variable-rate loans have interest rates that fluctuate periodically throughout the repayment term based on changes in an underlying benchmark index.
Common variable-rate loans include:
- Home equity lines of credit (HELOCs)
- Some mortgages
- Federal student loans
The interest rate is split into two components:
- Index – This baseline rate is outside the lender’s control and varies based on broader economic conditions. Common benchmark indexes include the prime rate and London Interbank Offered Rate (LIBOR).
- Margin – The margin is a fixed percentage added by the lender to cover administrative costs and profit. For example, if the index rate was 5% and lender margin was 3%, your starting APR would be 8%.
Together, changes to the index plus the margin determine your new rate each time it adjusts. Your payment adjusts accordingly based on the remaining principal balance and updated rate.
Rather than enjoying predictable installments like a fixed loan, your regular payments can go up or down every time the prevailing rates shift – usually annually but sometimes as often as monthly or quarterly.
This introduces uncertainty and the inconvenience of fluctuating payments, which makes financial planning and budgeting more difficult. However, starting payments are generally lower than fixed loans. And if index rates decline, your interest cost drops too.
How Variable Rates Are Determined
Variable interest rates are largely based on general economic conditions and prevailing rate environment using a benchmark index as a reference point rather than mainly an assessment of individual creditworthiness like fixed rates.
When the associated index changes, rates adjust accordingly. Some common variable rate benchmarks include:
- Prime rate – Interest rate charged by commercial banks to their most creditworthy customers. Generally among the lowest available rates.
- LIBOR – Interest rate charged when global banks borrow from each other. Currently being phased out and replaced due to manipulation allegations.
- Fed funds rate – Rate banks charge each other for overnight borrowing, directly influenced by Federal Reserve interest rate policy decisions.
- Treasury indexes – Yields on short-term U.S. Treasury securities are common benchmark indexes.
So when these underlying rates rise or fall in reaction to economic or Federal Reserve policy shifts, the interest rate and payments on variable loans linked to them change too in order to stay aligned.
Pros and Cons of Fixed-Rate Loans
Pros
Payment predictability
The biggest advantage of fixed-rate loans is the guarantee that your monthly principal and interest payment will never change. This reliability makes budgeting and financial planning much simpler since you’ll know exactly what to expect each month.
Protection from rising interest rates
With interest rates expected to rise further as part of the Federal Reserve’s inflation-fighting strategy, a fixed loan shields you from potential payment increases if benchmark rates climb higher in the coming years. Once your fixed rate is set, it won’t change regardless of what happens in the broader economy.
Easier comparison shopping
It’s simpler to compare pricing from different lenders when evaluating fixed-rate loan offers. The bottom-line interest rate and resulting monthly payments provide straightforward metrics. Make sure to verify all the inputs used to calculate APR for an apples-to-apples rate analysis.
Cons
No chance to benefit from declining interest rates
While payment stability has advantages, the locked-in rate could seem high later on if market conditions significantly improve. You won’t be able to refinance at a meaningfully lower rate since you’re stuck with the fixed rate agreed upon at origination.
Usually higher rates than variable loans
Because lenders face less interest rate risk with fixed-rate products, they don’t have to pad pricing as much allowing them to offer lower teaser rates on variable loans. But this doesn’t always hold up over the full loan term as we’ll explore further on.
Potentially costly to refinance
If prevailing rates decrease substantially, refinancing into a new fixed-rate loan at a lower rate can save on interest costs. However, refinancing brings closing costs including various lender fees. And if you don’t stay in the home long enough, you may not recoup the refi costs through a lower rate.
Pros and Cons of Variable-Rate Loans
Pros
Lower initial interest rates
In most rate environments, lenders can offer a lower starting rate on variable loans compared to fixed since the payments can rise protecting their investment if the associated index increases. Even if benchmark rates rise, there may still be savings earned on the lower rate enjoyed in early years.
Potential interest savings if rates decline
A key advantage of variable rate loans is they offer borrowers the chance to benefit from interest rate decreases over time. If the related index drops, your loan rate will fall in accordance with it allowing savings on interest.
Flexibility to refinance
Since variable loans shift along with the overall rate environment, you have the flexibility to more easily refinance if rates fall. This allows you to take advantage of better market pricing without the large fees incurred when refinancing a fixed loan before maturity.
Cons
Unpredictable payments
The uncertainty of fluctuating monthly payments makes financial planning and budgeting challenging. You’ll need to account for potential increases each time your variable rate resets to avoid payment shock down the road.
Vulnerable to interest rate hikes
While a variable loan lets you capitalize on rate declines, the flipside is your costs and monthly burden can dramatically increase if interest rates spike higher. Models suggest rates still have room to rise meaning sizable payment jumps are possible.
Total interest costs may exceed fixed loans
Due to lower initial teaser rates, variable loans often look much cheaper. But over the full loan term – like 30-years for a mortgage – short-term savings can easily be outweighed if rates trend higher leading to greater total interest expenses.
Which Loan Type Carries More Risk?
When deciding between fixed and variable rate loans, it’s critical to determine your risk tolerance. Due to fluctuating rates and payments, most experts suggest variable rate loans carry significantly more long-term risk than fixed.
Yes, you may save substantially if rates fall steadily. But economic cycles and interest rate changes are incredibly difficult to predict accurately, especially over decades for products like mortgages.
One certainty is payments on fixed-rate loans will remain stable. In contrast, when taking a variable loan you’re essentially making a bet that interest rates will decline meaningfully. If that doesn’t pan out, you could end up paying far more in total interest costs.
Below are key risks associated with variable rate loans:
- Payment shock – Potential for large payment increases if rates spike
- Difficulty budgeting – Harder to plan for retirement and other goals due to unpredictable payments
- Higher lifetime interest costs – Total savings depend on interest rate trajectory over full loan term
Ultimately, choosing between fixed and variable depends on your unique finances and ability to adapt if rates unexpectedly jump. Stable fixed payments provide certainty at the cost of missing out on deals if rates drop.
Key Factors In Deciding Between Loan Types
Determining suitable loan options for your situation involves carefully weighing priorities:
Financial Flexibility
How comfortably can you afford projected payment increases under variable loan terms? Run stress tests assuming a 2-4% hike in rates to see if you can still manage other goals. Those with tighter budgets may prefer fixed payment reliability.
Loan Term
The longer the term, the harder it is to predict where rates will be over decades. Shorter loans make variable more palatable due to lower likelihood of extreme rate changes within a few years.
Timing Within Economic Cycles
Entering a variable loan when interest rates are low and poised to increase allows more room for incremental rate hikes before payments become unmanageable. Whereas rates topping out signal less risk if floating lower.
Future Plans
Knowing you may move or refinance in a few years makes adjustable loans more favorable to capitalize on dips. If staying put longer, fixed rates ensure steady expenses.
In general, the more sure you are about your future income streams and how long until repayment, the more sense locked-in fixed rate loans make to provide certainty. Where variable loans allow flexibility that aligns better with changing life plans.
Questions to Ask Your Lender
To determine if a variable or fixed loan suits your borrowing needs, here are key questions to review with lenders:
Variable Rate Loans
- What index is the variable rate based on and how volatile has it been historically?
- How often can the payment amount change?
- Is there a rate cap limiting maximum interest rate and payment increases?
- Can I convert to a fixed rate later on and what costs are involved?
Fixed Rate Loans
- What benchmark indexes were used to price the fixed rates being offered?
- How do the rates compare to average industry pricing and expected rate trajectory?
- Are there any charges or penalties for paying off this loan early?
- Can I lock my rate now while rates are low?
Also, carefully go through payment scenarios under different rate assumptions and economic conditions to gauge how each loan would perform. This will determine which option provides the optimal risk-return profile.
Putting It All Together
Deciding between a fixed or variable rate loan carries high financial stakes. On one hand, variable rate loans often have lower initial payments and the flexibility to take advantage of dips in prevailing interest rates over time. But this comes at the risk of unforeseen payment spikes.
Fixed rates provide reliable monthly expenses and certainty about total repayment costs. Yet you lose out on potential savings from lower rates.
There’s no universally right loan choice. Each product carries advantages that suit different financial situations and consumer risk appetites. By weighing personalized factors like income stability, budget adequacy under a range of scenarios, timing, and plans to move or refinance, borrowers can determine the interest rate methodology that makes the most long-term sense for their situation.
But regardless of whether you pick fixed or variable, the most important rule when borrowing money is only taking on what you can reasonably afford including some buffer for fluctuations in the case of adjustable-rate products.
Conclusion
Choosing between a fixed or variable rate loan is one of the most significant lending decisions. Loan types with fluctuating payments and rising rates introduce uncertainty and risks compared to the reliability of fixed. There’s a reason they call them “adjustable mortgages” – the adjustment can go either way!
Carefully compare how each option aligns with your budget, risk tolerance, and plans. Evaluate your situation both now and where it may be years down the road accounting for life changes.
While prevailing interest rates hovering near historic lows may point to variable, guaranteeing budget certainty has real value too. There’s merit to each approach depending on individual circumstances.
By understanding how fixed and variable loans work, analyzing the pros/cons, and asking the right questions, you can make a well-informed borrowing decision providing the best financial outcome over the long haul.