Choosing an interest rate is a lot like choosing a romantic partner.
A variable rate loan is a mysterious and unpredictable stranger. You know it’s full of surprises but you can’t tell whether they’re good or bad yet.
Is it worth the risk, though?
Or should you stay with your long-term partner, the fixed rate?
Sure, there might be something better out there. But you value the loyalty and stability the fixed rate gives you.
Which one will you choose? Variable or fixed rate?
We hate to disappoint the romantic in you, but in this case, “follow your heart” might not be the best advice.
So, below we discuss the pros and cons of variable vs fixed rate.
Read on and see which will win over your heart.
What Is a Fixed Rate?
A fixed rate doesn’t change throughout the life of the loan.
The financial institution determines it at the beginning. If you agree to the terms, it remains the same until you pay off the credit.
The lender determines the fixed rate based on a number of factors. The main ones are your creditworthiness and the type of loan.
The main benefit of a fixed rate is that it protects you from rising interest rates. Plus, the monthly payment remains the same, which makes budgeting easier.
That said, if the interest rate market falls, you’ll miss out on better offers.
What Is a Variable Rate Loan?
Variable rates can change during the loan term. The variations are usually small, but they add up quickly with bigger and long-term credits.
Variable rates loans often have lower interest than fixed ones. But you could also end up paying more in time.
This makes them a riskier choice.
In addition to the factors influencing the fixed rate, the variable rate depends on the economic conditions and the resulting market changes.
How Do Variable Interest Rates Work?
Variable interest rates have two main components: base rate and margin.
The base rate is the part that changes. It is tied to one of two financial indices—the Wall St Journal prime rate or the LIBOR rate.
The prime rate is the interest that the Federal Reserve sets for banks to borrow money from each other.
The London Interbank Offered Rate (LIBOR) is tied to the London wholesale money markets.
When these indices fluctuate, the base rate changes accordingly.
The margin is the percentage added to the base rate. Together, they form the interest that borrowers will pay.
Once determined, it doesn't change throughout the life of the loan.
Loan Cap
Loan caps protect borrowers from excessive interest increases. It limits how much variable rates loans can grow over a certain period or the life of the loan.
Initial caps determine the maximum percentage lenders can charge at the beginning of the loan.
Periodic caps limit the amount of interest thе creditor can charge you each adjustment period.
Lastly, lifetime caps determine the maximum interest rate the financial institution can charge over the life of the loan.
What Types of Credit Offer Variable vs Fixed Rate?
Most types of credit come with both fixed and variable rates.
Auto Loans
Auto loans are car purchases on credit. They usually have fixed interests. Variable rates are rare.
Plus, a fixed auto loan means predictable monthly payments. It’ll be easier to manage even if you’re on a tight budget.
Mortgages
Mortgages are a type of loan used to purchase a home. The credit is secured by the home itself, so the interest is lower.
A mortgage loan can be with a fixed or variable rate.
Fixed-rate mortgages offer stability and predictability. The downside is that the terms usually make it harder to sell the property.
Variable-rate mortgages usually have a lower initial interest. The downside is that it will likely increase over time.
If you’re planning to refinance the loan, though, the variable rate is better. You’ll benefit from the lower interest in the beginning.
Personal Loans
Is a personal loan rate fixed or variable? It can be both.
And since you can use this type of credit for any purpose, your choice will depend on different factors.
If you want to take on a short-term loan, check what variable rate the lender will offer. If it is lower than the fixed rate, we recommend choosing this option.
That said, a long-term payment plan might be easier to manage with a fixed rate.
Credit Cards
A credit card allows you to borrow money up to a certain limit to purchase items or withdraw cash.
Credit cards are with variable or fixed rates. That said, the former is much more common.
Either way, interest with this type of credit account can accrue quickly if you carry a balance. But if you repay the whole sum on time, you can avoid paying interest altogether.
HELOCs and Home Equity Loans
HELOCs, or home equity lines of credit, are secured recurring credits which use your property as collateral. These types of home loans have variable rates.
Home equity loans also use your property as collateral. Unlike HELOCs, they provide the entire amount at once. These loans offer a fixed rate.
Student Loans
Student loans offered by the government usually have fixed rates. Those from private institutions come with variable interest.
When trying to decide whether to get a student loan with a variable or a fixed rate, you need to consider a few things.
First, are you planning to refinance the loan?
Do you have any credit history and a good credit score?
If the answer to both questions is yes, then you should get a variable rate. Otherwise, a federal loan with a fixed rate might be the better option.
Variable vs Fixed: Which Interest Rate Is Better?
The answer to this question depends on several factors.
The first is the type of credit. With some loans, like HELOC and home equity, you won't have that choice at all.
With mortgages, for example, you need to think about your future plans. If you want to sell the property or refinance the loan, you might be better off with a variable rate. Otherwise, a fixed rate is the safer choice.
You also need to consider the length of the credit period. Variable rates are usually best for short-term loans. Fixed interest rates are more suitable for long-term loans.
Next, take into account the state of the interest rate market. If the prime or LIBOR rate is rising, variable rates will be higher too.
If they're decreasing, though, check out the variable-rate loan options. If you take on a short-term loan and your interest rate is decreasing, you'll pay it off in no time.
Last but not least, you need to consider your risk tolerance. Variable rates are riskier than fixed rates.
If you're not comfortable with the uncertainty, save yourself the trouble and get a fixed-rate loan.
Wrap Up
Variable vs fixed rate: which one is better?
There's no universal answer to this question.
There are pros and cons to each type of rate.
The choice depends on your risk tolerance, the type of credit, the length of its term, and the interest rate market.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.
