Not all loans are created equal. Some loans have a fixed rate and others have a variable rate.
If you plan to take out a loan, you should shop for the best loan to meet your needs and financial situation. When you’re looking to borrow, always pay attention to the annual percentage rate. This determines how much it’s going to cost you to borrow the money for your purchase.
Knowing the difference between a fixed rate and variable rate loan can help you make a smart financial decision.
What it is: A fixed-rate loan is when the initial interest rate stays the same throughout the life of the loan. In other words, the rate you get when you take the loan is the same until you pay it off. Your rate is locked in, so if market interest rates fluctuate, your rate won’t change. This means that your monthly payments will also be the same. When you budget, you can account for the same amount every month.
Pros: Financial planner Justin Pritchard says fixed-rate loans are generally safer than variable-rate loans because you know what to expect, and you can plan for the future. If you are working within a fixed monthly budget, a fixed-rate loan could be the better choice for you. You can plan for the expense because the amount due is never going to change. If you know you aren’t going to pay the loan off quickly, or if your income is uncertain or inconsistent, this could be a stable option. For example, contractors and freelancers could benefit from fixed rate loans.
Cons: While fixed loans can be stable and consistent, they normally have higher starting interest rates than variable-rate loans. And you won’t be able to reduce your interest rate
What it is: With variable-rate loans, the interest rate fluctuates or varies as market interest rates change. This means your monthly payments can go up or down at any time.
Matt Lee at Investopedia says studies show that borrowers pay less interest over the long term with a variable-rate loan versus a fixed-rate loan. This is because variable-rate loans have lower starting interest rates than fixed-rate loans But with variable-rate loans, everything depends on how the market changes.
Pros: Variable loans can save you money with their lower interest rates. This is a great option if you plan on paying off your loan quickly. For example, if you’re borrowing a small amount, then variable rate loans can save you a lot in the short term.
Cons: But, if they start going up, the loan can end up costing you significantly more than what you originally budgeted for. As Lee notes, the length of the loan is a key factor in the risk of variable-rate loans. The longer the term, the more opportunities for change and the more impact those changes can have on the total cost of the loan.
Some lenders set caps that limit how much the rate can go up over the life of the loan. When shopping for a variable-rate loan, the Consumer Financial Protection Bureau suggests that you compare rate caps of different lenders and ask the lenders to calculate the highest payment you may ever have to make on the loan.
These loans can be excellent for borrowers who are able to pay a loan back quickly, as the risk of an interest-rate bump decreases due to the short term.
Know Your Tolerance for Risk
Your risk tolerance is going to be a key factor in choosing between fixed and variable term loans. Anna Miller at SmartAsset suggests asking yourself how much risk you can afford.
The answer to this question heavily depends on you and your situation. For people who have short term loans and want to save big, the variable rate loans may be your best bet. If you have a longer-term loan or need some stability in your budget, fixed rate loans could benefit you. Know yourself, know your budget and know your options to ensure you choose the right loan for you.