Fixed vs. Variable Interest Rates: What is the Difference?

Fixed-rate loans are the same interest rate throughout the loan period. Variable-rate loans change over time. Fixed-rate loans are better for those who want predictable payments. They won’t increase or decrease in cost. Variable-rate loans will have a fluctuating rate of interest. This means that the price of variable rate loans will increase or decrease over time. Borrowers who think interest rates will fall tend to choose variable-rate loans. Variable-rate loans generally have lower interest rates and can be used to finance short-term needs.

Fixed-Rate Loans Explained

Fixed-rate loans have interest rates that remain the same throughout the term. The cost of borrowing money will not change due to fluctuations in the market. A fixed-rate is an installment loan such as a mortgage, personal loan, or car loan. It allows the borrower to make regular monthly payments.

The 30-year fixed-rate mortgage is one of the most sought-after fixed-rate loans. Fixed-rate mortgages are popular because they allow homeowners to budget and plan for their payments. This is particularly helpful for those with stable finances. It protects them from rising interest rates, which could increase the cost of their loan.

Take-aways

  • Fixed-rate loans have interest rates that remain the same throughout the loan’s life.
  • Fixed-rate loans are preferred by consumers who value predictability.

Variable Rate Loans

Variable-rate loans have an interest rate that changes over time to reflect market conditions. Many fixed-rate consumer loans are available. However, there are some options with variable rates, such as mortgages, private student loans, and personal loans. Although auto loans are typically only available at a fixed rate, specialized lenders and banks in the U.S. may offer variable rates. The 5/1 adjustable-rate mortgage is one of the most sought-after loans in this group. It has a fixed rate for five years, then adjusts each year.

Variable-rate loans generally have lower interest rates than fixed versions. This is partly because they are riskier for consumers. Variable-rate loans can have higher interest rates, which can increase borrowing costs. Consumers who opt for variable rate loans need to be aware of the possibility of high loan costs. Variable-rate loans can be a viable option for those willing to take on risks and who can repay their loan quickly.

How variable rate loans work

Variable-rate consumer loans tied to the London Interbank Offered Rate repay, also known as LIBOR or the Prime Rate, are the most common. Financial institutions use these benchmarks to determine the cost of money. For variable rate loans, lenders use LIBOR or the Prime Rate as the baselines. A margin is added to the benchmark rate to calculate the consumer’s rate.

Like other types of debt, the interest rate and margin a borrower gets on a variable-rate loan are highly dependent on credit scores, lender, and product. Credit card companies, for example, use the Prime Rate published in the Wall Street Journal each month to determine the interest rates consumers will receive in the following month. A Prime Rate of 4.25% plus an additional margin of 7%- 20% means that a consumer with excellent credit could receive an extra 10% margin, which would result in an interest rate of 14.25%. For riskier loans, borrowers with lower credit scores, and shorter-term loans, margins tend to be higher.

Interest-Rate Caps

Most variable rates have ceilings that can protect borrowers from the possibility of benchmark rates reaching extremely high levels. The caps are usually set at high levels and cannot protect against unpredictable market movements. Fixed-rate loans are best for long-term affordability in low-interest rates. Take a look at the 7.95% fixed rate for a 7-year personal loan from SoFi. The interest rate cap is 14.95%. This is almost twice the fixed rate.

The interest rate cap structure for most adjustable-rate mortgages is broken down into three distinct caps. The initial cap defines the maximum rate that can be changed; the periodic cap limits how much a rate may change over each adjustment period; finally, the lifetime cap controls how high a rate could go.

Rate Cap Structure for a 5/1ARM with an Initial 3.75% Interest rate

  • Initial cap 1.5%: Rates can rise as high as 5.25% or as low as 2.25% in the first adjustment period
  • Periodic cap of 2 %: If the rate increases to 5.25% in the first period, it can be as high as 7.25% or as low as 3.25% in the second period. In subsequent periods, the rate may adjust by up to 2% from its previous period.
  • Limit of 10% for life: Rates can only be increased to 13.75%

You can choose between a fixed and variable rate loan

It is important to evaluate your financial situation before you take out any loan. These factors will help you choose between a fixed and variable rate option. Remember that the interest rate is only part of the overall cost of a loan. Other factors such as term length, lender fees, and servicing costs can also impact the total cost.

Student Loans

The federal fixed rate option for people with poor credit scores or little credit history is the best choice if they are eligible for a loan from the government. The government sets federal rates. They are not adjusted for each borrower’s financial situation, unlike other loans. On the other hand, a variable rate loan can be secured at a lower rate for students with good credit or those looking to refinance.

Most student borrowers finance their education using federal loans. These loans have fixed rates and are mainly used by students. Variable-rate loans are also available to those who choose between federal and private loans or are looking at refinancing.

Mortgages

The interest rates on mortgages are still at historic lows. Therefore, a fixed-rate 30-year mortgage will provide affordable repayments. An adjustable-rate mortgage is a good option for potential homebuyers looking to sell their home or refinance their mortgage. Their lower rates make them less expensive in the short term.

It is crucial to decide how long you will be able to keep a mortgage. An ARM will adjust at a rate that is higher than the fixed rate. On a long-term debt obligation such as a mortgage, the difference in interest rates of 0.25% and 0.50% can add up to tens of thousands of dollars over thirty years.

Personal loans

Fixed-rate personal loans, as mentioned above, are a good choice for people who prefer predictable long-term payments. Fixed-rate loans can be a good option for those who want to make affordable monthly payments over the long term, whether it’s for a 7- or 10-year loan. On the other hand, variable-rate loans can be a cost-effective way to pay off debt quickly or get a lower monthly payment in the future.

Like private student loans and mortgages, your interest rate will be determined by factors such as credit score and debt to income ratio. You can get the lowest interest rates by being responsible for your finances and improving your FICO credit score.