Learn about fixed rates vs variable rates. Read about what they are, examples of fixed interest rates and variable rates, and how they apply to loans.
Whether you have a variable interest rate or a fixed interest rate can significantly impact the life of a loan and the annual percentage rate (APR) you end up paying.
Variable rates can change your interest charges over time while fixed rates remain the same, but there’s also a lot more to the decision between fixed rates vs variable rates.
When you take out a loan, you are carrying a balance until the loan is repaid, and fixed vs variable interest rates change how the interest accumulates on this balance.
What are Fixed Interest Rates?
Fixed interest rates are a type of loan interest rate that doesn’t change throughout the life of the loan. The interest rate on your loan is not linked to any benchmark or index but is instead decided upon when entering the fixed-rate loan contract.
Monthly payments on a fixed-rate loan do not change during the loan’s life but remain constant. Instead of letting the market decide, lenders offer certain APR ranges to their customers.
They'll often look at things like credit scores instead and offer prime rates to customers with excellent credit and higher rates to customers with subprime credit to offset their risk.
Pros and Cons of Fixed Rates
Fixed-rate loans offer borrowers predictability and stability, simplifying financial planning and budgeting. They also provide security during economic uncertainty and make it easy to compare loan options.
However, fixed interest rates often come with higher initial interest rates and may include prepayment penalties, which can be more costly. They can also be a less flexible option since the rate stays the same.
Fixed Rate Loan Examples
There are many kinds of fixed-rate loans, each serving different financial needs and goals. Some common examples include:
- Fixed-rate mortgages: These are home loans in which the interest rate remains constant throughout the loan term, typically 15, 20, or 30 years. This provides stable monthly payments.
- Fixed-rate credit cards: Unlike variable-rate credit cards, these have a consistent interest rate, keeping the cost of borrowing the same over time.
- Payday loans: These are short-term loans that usually come with a fixed interest rate and must be repaid by the borrower's next payday. They are often used for emergency expenses but may come with higher annual percentage rates (APRs).
- Investment bonds: Bonds issued by governments or corporations often come with fixed interest rates, providing predictable returns to investors over a specified period.
- Auto loans: These loans finance the purchase of a vehicle, and fixed interest rates maintain consistent monthly payments throughout the loan term.
- Personal loans: Fixed-rate personal loans are used for various purposes such as debt consolidation, home improvements, or major purchases, offering a steady repayment schedule.
Each fixed-rate loan type offers stability and predictability, making them attractive to borrowers seeking to manage their finances with minimal surprises.
What are Variable Interest Rates?
Variable interest rates are a type of loan interest rate that is linked to a financial index or benchmark and changes with the market.
When comparing fixed-rate vs variable-rate loans, variable rates will change with the market instead of remaining the same. The interest that gets applied to a loan is directly linked to the interest rates on the market. So, as the market's rates increase, so does your loan rate. As market rates decrease, your variable interest rate will decrease as well.
Payments on this type of loan also vary according to what's happening in the market, meaning you could potentially save money when the market does well. However, that also means there's the potential to not save money as market APRs range higher.
Pros and Cons of Variable Rates
Variable-rate loans, also known as adjustable-rate loans, can offer lower initial interest rates than fixed-rate loans. This can result in lower initial monthly payments and significant interest savings if market rates remain low.
However, the downside is the uncertainty and potential for rate increases, which can lead to higher monthly payments and overall borrowing costs if interest rates rise. To sum up, variable-rate loans can offer cost savings in favorable interest-rate environments but carry a higher risk of financial volatility.
Variable Rate Loan Examples
There are many examples of variable-rate loans, each serving different financial needs and situations. Some common examples include:
- Variable-rate mortgages (adjustable-rate mortgages or ARMs): These home loans have interest rates that can change periodically based on an index, leading to fluctuating monthly payments. They often start with a lower fixed rate for an initial period before adjusting.
- Variable-rate credit cards: These credit cards have interest rates that can change based on the prime rate or another index, affecting the cost of carrying a balance month to month.
- Variable-rate personal loans: These loans can be used for various purposes, such as debt consolidation, home improvements, or major purchases. Their interest rates can adjust over time, potentially leading to varying monthly payments.
- Investment bonds: Some bonds, particularly certain corporate or municipal bonds, come with variable interest rates that can change based on market conditions or specific benchmarks.
- Home equity lines of credit (HELOCs): These loans allow homeowners to borrow against the equity in their home with interest rates that can change over time, often tied to the prime rate.
- Student loans: Some private student loans offer variable interest rates, which can lead to changing monthly payments over the life of the loan based on market rate fluctuations.
Each variable-rate loan type offers the potential for lower initial costs but comes with the risk of increased payments if interest rates rise, making them suitable for borrowers who can manage the potential financial variability.
Fixed Rate vs Variable Rate: Which Is Better?
On a surface level, when comparing fixed rates vs variable rates, you might think a fixed interest rate is better than a variable interest rate because it stays the same throughout the life of the loan. However, the changeable nature of the variable interest rate can sometimes work in your favor, allowing you to pay less in interest over the life of the loan.
Some studies have found that borrowers are likelier to spend less overall with varied interest rates. But, this could prove untrue for someone taking on personal loan interest rates when the market is not doing well. Studies of how interest rates have done in the past don't necessarily mean they will continue to do well in the future.
Meanwhile, a fixed interest rate provides stability so you know what to expect in monthly payments every time and exactly how much you'll pay in interest charges now. But you could lose out on the opportunity to save money if the market does well and lowers your rates.
When trying to decide between fixed rates vs variable rates, it's important to consider several factors:
- Current market trends
- Market forecast for the future
- Type of loan or credit
- Loan term
Here’s a quick look at the pros and cons of fixed rates vs variable rates.
Find the Best Interest Rates for Your Needs
Whether fixed rates vs variable rates are better or worse than the other depends on different factors. Sometimes, variable-rate loans will be better if the current market trends are good and the market forecast for the future also looks promising. But if the market forecast looks bleak, a fixed-rate loan might be better.
Which fixed rate vs variable rate you should choose really depends on your own personal finance situation, the kind of credit you are seeking out, and the market trends relevant to your loan. Make sure you consider all of these factors together when deciding between a fixed rate vs variable rate.
