Fixed vs. Variable Loans – Key Differences
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If you’re planning on taking out a loan, one factor you need to take into consideration is the interest rate, and you’ll need to understand the differences between variable interest rates and fixed interest rates. Deciding which is best for you depends on a variety of factors, so you’ll want to read on to learn:
Fixed vs. variable rate loans – basic differences
Fixed Loans | Variable Loans | |
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Initial interest rate | May be higher | May be lower |
Interest rate over time | Does not change over the life of the loan | May change based on a rate index |
Loan length | Better for long-term loans | Better for short-term loans |
Risk level | Lower | Higher |
Monthly payments | Stay the same over time | May increase or decrease |
These are just a few of the key differences, so to learn more about each time, continue reading.
What is a variable interest personal loan and how does it work?
A variable interest rate personal loan is a personal loan in which the interest rate varies as market interest rates change. The rate is linked to an underlying benchmark or index, such as the:
- London Interbank Offered Rate (LIBOR)
- Secured Overnight Financing Rate (SOFR)
- Prime rate, which means the interest rate charged on the loan’s balance can increase or decrease over time.
This also means that your payments can vary from month to month. While variable interest loans often have lower starting interest rates than other types of loans, the rate and payment amounts can increase to be higher than those loans.
Lenders use the LIBOR, SOFR, or prime rate as baselines for the rate for a variable loan, and then they add a margin on top of that benchmark rate to calculate the rate that will be offered to the borrower. The margin is the percentage points added after the initial rate period finishes.
The margin and interest rate are also dependent on factors such as the lender, loan product, and borrower’s credit. For example, if the prime rate is 4% and has an added margin of 6% to 15%, a borrower with good credit may have a 10% margin added, receiving an initial interest rate of 14.00%.
To help protect consumers from extremely high rates, there are interest rate caps on variable loans. While these are also often set relatively high, it can help protect borrowers from paying an endless amount of interest. However, rising interest rates can significantly increase the cost of borrowing money, so it’s important to be aware of this potential and prepare for it.
Pros and cons of variable loans
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What are fixed interest rate personal loans and how do they work?
Fixed interest rate loans are the opposite of variable loans. With fixed rate loans, the interest rate does not change over time. The rate charged on the loan when it’s incurred will be the rate for the entire term, regardless of the market. This means, the rate stays at the prevailing market interest rate at the time the loan was taken out, plus the impact from the borrower’s credit.
With a fixed-interest rate loan, your payments will also be the same each month, and it’s easier to calculate how much you’ll be paying in interest over time. It can also make budgeting and planning easier.
When you apply for a personal loan, the lender will calculate the personal loan you receive by taking into consideration factors like your credit score, credit history, income, debt-to-income ratio, credit utilization, and others. The rate they give you when you are approved for the loan is what it will be for the entire loan term.
Lenders usually have rate ranges listed on their website, but by getting prequalified for the loan, you’re able to better compare unique interest rates you’d likely receive from different lenders.
Because the rates don’t change, you can then easily calculate how much in interest you’ll be expected to pay and can rest assured your monthly payment won’t change.
Pros and cons of fixed rate loans
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Fixed vs. variable rate loans – Which is better?
If you’re wondering which rate is better, the answer is that it depends. Consider your personal financial situation and the specifics of each loan. Also consider your flexibility and willingness to take a risk.
You may want to consider a fixed rate loan if:
- You want a consistent monthly payment.
- You plan to pay your loan back over a longer period.
- You don’t want to take the risk of interest changes over time.
- You have a high credit score that will allow you to secure a lower initial rate.
- The economy is unsettled.
- You’re on a tight budget, have job instability, or specific financial goals that can’t account for the risk associated with variable rates.
On the other hand, you may want to consider a variable rate loan if:
- You want to take advantage of the maximum possible savings.
- You have the financial ability to make higher monthly payments and pay more in interest if rates increase.
- You plan to pay off your loan over a shorter period.
- You don’t mind the risk.
- The economy is stable.
While a variable rate loan may be better during a time of decreasing interest rates, you’re taking a risk of those rates then increasing if the market conditions change. On the other hand, while fixed rate loans could be more expensive, they are easier to budget and plan around and there’s no risk of the rate increasing even more.
Student loans
Federal rates are predetermined by the government, so if you are eligible for a federal student loan, choosing the fixed rate option is best (especially for those with little credit history or poor credit scores.)
However, if you have good credit or are looking to refinance, choosing a variable private loan may help you secure a lower rate.
Auto loans
Typically, auto loans are only available with a fixed rate (though some lenders do offer a variable rate option). A fixed rate car loan is ideal for longer-term financing because the APR and payment will never change over the duration of the loan.
Mortgages
Mortgage interest rates fluctuate constantly, so it’s important to pay attention to market conditions and determine the length of time you plan to have a mortgage. If you’re looking to sell your home or refinance after a few years, you may benefit more from an adjustable-rate mortgage (ARM) because their lower initial rates make them more affordable in the short-term.
That said, if you have a long-term debt obligation, a fixed rate could save you tens of thousands of dollars over the loan’s term.
Other factors to consider when deciding on the type of interest rate you want to pay
1. Interest rate trends and forecasts
It’s important to consider the market when deciding which type of loan rate is best for you. For example, if interest rates are low or you believe they are increasing soon, you should take out a fixed rate loan. On the other hand, if rates are high or you believe they will be decreasing, consider a variable rate loan.
2. Loan term
Consider your loan’s term or the amount of time in which you must repay your loan. Because no one can tell the future, it can be tempting to choose your loan rate type based on today’s market conditions, especially if you have a shorter loan term. On the other hand, longer loan terms may need additional consideration and analysis to calculate how rates will change over the years.
Generally, the longer your repayment term is, the more you’ll have to pay in interest but your monthly payments will be lower. The shorter the term, the higher your payments but you’ll owe less in interest.
3. Your personal income
It’s important to be able to make your loan payment each month, but you also need to be able to pay your other bills and expenses. Deciding whether a fixed or variable rate loan is right depends on your own personal income and job situation, including stability, potential salary growth, and current savings.
For example, if you have great job security and predict a higher income in the coming years, a variable rate loan is less risky because you’ll have more income when rates are higher. On the other hand, if your job is not secure or you don’t anticipate growth, a variable rate may be too risky.
4. Spread of interest
Interest rate spread is the difference between the interest rate a bank pays to depositors and the interest rate it receives from loans, or the difference between the borrowing and lending interest rates. Always consider the terms for both types of loans. Even though one may be more expensive, the difference between the spread may help you choose.
5. Fees
Lender fees can increase the total cost of the loan. These can include origination fees, application fees, underwriting fees, late payment penalties, early payoff penalties, and more. Be aware of the fees each lender charges on the different types of loans.
FAQs
It depends. Often, economic conditions can influence which rate is lower. For example, rates may be lower during a recession, but can increase to slow the economy to combat inflation. It can also depend on each borrower. Well-qualified borrowers with excellent credit scores will be offered a lower rate than those who are less qualified or have poor credit scores.
Because the interest rate can change at any time, the primary danger is the rate increasing. There’s no way to know for sure what your rates will be in the future, which can make it more difficult to budget for and ensure you have enough income to cover your payments and other expenses. Higher rates can make the loan payments more difficult to pay.
Yes, most lenders allow this to happen at any time, though there are usually fees associated with converting the loan terms.
Yes, one of the major benefits of a variable rate loan is that the rates can decrease over time, lowering your monthly payment and saving you money.
To get a low interest loan, the first steps you’ll want to take are to improve your credit score and lower your debt-to-income ratio. Shop around to compare lender rates and find the lowest ones, but be sure to avoid fees if possible. Adding a co-signer or taking out a secured loan using collateral can lower your rate, as can signing up for or taking advantage of discounts. Credit unions often offer loans with lower rates for members, and you can also opt for a shorter repayment period, so your payments will be higher but you’ll pay less in interest.