When you borrow money for purposes such as a mortgage, car loan, student loan, or personal loan, the interest rate you agree to significantly impacts the amount you repay in the future. There are two main types of interest rates: fixed and variable. To make an informed loan choice, you need to understand the difference between these two types of interest rates. This depends on your financial goals, your risk tolerance, and the type of loan you want to apply for. This guide explains the advantages and disadvantages of fixed and variable interest rates. Anyone signing a loan agreement should consider these factors.
What does a fixed interest rate mean?
A fixed interest rate is an interest rate that remains constant throughout the term of the loan. If you borrow money at 6%, that rate remains constant, and you always know how much you pay each month. Long-term loans, such as mortgages, often have fixed interest rates because they are more stable and easier to plan for.
What are variable interest rates?
Variable interest rates (also called floating rates) can change over time as the market changes. These rates are often linked to a standard rate, such as the prime rate or the London Interbank Offered Rate (LIBOR). Your interest rate changes as average interest rates rise or fall. In other words, your monthly payments can increase or decrease over the life of your loan. Credit cards, some personal loans, and variable-rate mortgages all have interest rates that change from time to time.
Fixed interest rates have several advantages.
The biggest advantage of a fixed rate is stability. Because the interest rate doesn’t change, you always know how much you’ll pay each month. This makes it easier to plan and stick to your budget. If market interest rates rise, people with more volatile loans may have to pay higher fees to borrow money. A fixed rate also protects you from this risk. Fixed interest rates give many people a sense of security when entering into long-term financial agreements.
Disadvantages of Fixed Interest Rates
The biggest problem with fixed interest rates is that they can initially be higher than variable rates. Fixed loans are more expensive because lenders want to ensure loans can be repaid on time. If market interest rates fall, people with fixed rates won’t save money unless the interest rate changes. This can increase the cost and take longer to repay.
Advantages of Variable Interest Rates
Variable interest rates are typically lower than fixed rates at the time of the initial payment. This makes variable rates ideal for short-term loans. If market interest rates remain the same or fall, people with variable rates can save more money than those with fixed rates. For people who want to pay off their loan quickly, a variable rate can be a good choice.
Disadvantages of Variable Interest Rates
The biggest risk of a variable rate is its unpredictability. If market interest rates rise, your monthly payments can increase significantly, which can put a strain on your budget. In the long run, a variable rate can be more expensive than a fixed rate. Anyone who wants to know exactly how much money they’ll have left or struggles to manage frequently fluctuating payments might not choose a variable-rate loan.
When is a fixed-rate loan a good choice?
In most cases, fixed-rate loans are best suited for longer-term loans, such as 15- or 30-year mortgages, or if you simply want to be sure your payments will never change. Fixed-rate loans can also be a good option for people on a tight budget who can’t handle sudden monthly payment increases.
When is a variable-rate loan a good choice?
If you want to pay off your loan quickly or don’t mind taking some financial risk, a variable-rate loan can be a good choice. If market interest rates remain the same or decrease, a variable-rate loan can save you money. This is especially true for personal loans and student loans that you plan to repay over several years.
Things to consider before choosing
When choosing between a fixed and variable interest rate, consider your financial goals, the loan term, and the risk you’re willing to take. Consider the following questions:
- How long will it take me to repay this loan?
- If interest rates rise, can I borrow more?
- Am I willing to choose a mortgage even if the costs are higher?
- Can I refinance or pay off my loan early?
The best interest rate for you depends on your answers.
It’s attractive because the interest rate starts low but rises over time.
Can I switch from a variable rate to a fixed rate later?
Some lenders allow you to modify or transfer your loan, but there may be a fee. Check your loan terms to see if this is permitted.
How much can the interest rate on a variable rate increase?
This depends on the terms. Some variable rate loans have a maximum increase within a certain period or over the life of the loan.
Which type of loan is most suitable for a mortgage?
For most people who plan to stay in their home for a long time, a fixed rate offers more stability. On the other hand, if you plan to sell your home in the next few years, a variable rate mortgage can save you some money initially.
Summary
Fixed and variable rates both have their advantages and disadvantages. Fixed rates are ideal for buyers who want a fixed rate because they are stable and predictable. However, variable interest rates carry higher risks. While variable interest rates may offer lower upfront costs and can save you money in a favorable market, they also carry a higher risk. The best option for you depends on your goals, financial situation, and risk tolerance. Understanding the differences between different loans and carefully weighing your options can help you make smart borrowing choices that will secure your financial future.
