Fixed-Rate vs. Variable-Rate Loans – Which is Right For You?
You’re taking out your next loan and you’re comparing the differences between a fixed interest rate and a variable interest rate. The variable-rate loan is lower than the fixed-rate, but the fixed-rate seems like a safer bet.
Committing to a variable or a fixed interest rate could mean the difference of saving, or spending, on interest over the life of a loan. Knowing the differences could help you make the right choice in the long run.
What’s the Difference Between Fixed-Rate and Variable-Rate Loans?
A fixed-rate loan has an interest rate that will not change throughout the life of the loan. The same interest rate you have when you took it out will be the same when you pay it off.
A variable-rate loan has an interest rate that can fluctuate based on a market interest rate. This means that when the market interest rate changes, your interest rate can also change. A market interest rate is chosen by the lender and is used to calculate both the fixed and variable interest rates you may have been offered. The interest rate you have when you take out the loan, may not be the same in a few months’ time. In fact, a variable interest rate will likely change as you pay the loan off.
Pros & Cons of a Fixed-Rate Loan
A fixed interest rate can offer safety. With a fixed-rate loan, your payments will stay the same over the life of your loan, which allows you to plan and budget long into the future.
While fixed loans can offer stability, the interest rates typically start higher than their variable-rate siblings. This means that you could pay more over time in interest with a fixed-rate loan if variable rates drop. But, if variable rates rise, you could also be saving on interest because your fixed-rate loan is locked in at a lower rate.
Why select a fixed-rate loan? Many people choose a fixed-rate for long-term loans, such as mortgages, because they don’t know what the market will look like in 15–30 years. They want to count on the consistency that a fixed-rate loan offers.
Pros and Cons of Variable-Rate Loans
Variable interest rates will typically start lower than fixed rates, but they run the risk of increasing. This means that your monthly payments can unpredictably go up or down over the life of your loan.
Variable rates often change because of economic factors, such as the Fed increasing or decreasing the federal funds rate. This is why it’s often big news when the Fed cuts or increases rates. Changes to the federal funds rate can affect a lot in the economy, including the variable rates of your loans (including mortgages) and credit cards.
While changes to your monthly payment can be shocking sometimes, lenders may be able to help you plan. When shopping for variable interest loans (especially for mortgages), 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.
Why select a variable-rate loan? Many people go with a variable rate for short term loans, or loans they plan to pay off quickly. They may also select a variable-rate loan if they have a reason to believe their interest rate will decrease over time.
Fixed-Rate or Variable-Rate: Which One Is Better?
There isn’t a right or wrong answer when deciding between a fixed or variable interest rate loan. But you can make a well-informed decision based on your money and your plans. Understanding your finances, what the terms of your loan offers are, and what your tolerance for risk is right now (and in the future) can help.
Questions to Ask Yourself When Deciding Between a Fixed and Variable-Rate Loan:
- Am I open to the risk of change that a variable rate loan offers?
- What are my financial plans in 5 years? 15? 30?
- How long is the term of the loan?
- How much do I expect to pay in interest on a fixed-rate loan?
- Does the variable-rate loan have a rate cap? What is the highest possible payment I could be making?
- Am I prepared to pay more each month if the variable rate increases? Am I prepared to pay more in 5 years?
- Does anything in the economy signal a market change could be coming? If so, will it help or hurt a variable interest rate?
While there is no way to know what the future might hold, knowing the differences between fixed and variable-rate loans can help you understand what could happen and prepare you for what comes next.