When it comes to determining your loan interest rates, there are two types of indicators you can choose from. The first one would be the fixed-rate while the other one would be the variable rate.
Understanding the difference between the two is essential if you are considering taking out a loan. Whether it’s for a new mortgage, refinancing your existing mortgage, getting a personal loan, or a credit card, knowing the difference between the two indicators can help you with your financial goals and might even save you some money.
What Are Fixed Rate Loans and How Do They Work?
If you take out a loan, you are required to pay interest. And when you choose a fixed-rate loan, the interest rate will remain the same from the beginning of the loan term until the end. This means no financial index can influence the interest rate you agreed with the lender. Moreover, most borrowers choose a fixed-rate loan for long-term loans because it offers accurate monthly payments and future costs.
Suppose you are taking out a ten-year mortgage to purchase a house. You will most likely choose to get a fixed-rate loan since it has a longer loan term. This is to avoid any fluctuation of interest rates during the life of your loan. That way, you can also avoid an increase in your mortgage payments.
Taking out a fixed-rate loan means the same interest rate for the entire loan term. This also means you will have the same monthly payments and loan costs until you finish paying back the loan in full.
The decision to choose a fixed-rate loan will depend on the loan term and the interest rate environment at the moment. If interest rates are increasing, this means your loan will cost you more. However, if the interest rate is currently low and is expected to increase over time, it would be best to choose a fixed rate to save some money.
Fixed-Rate Loan Benefits
The following are the benefits of choosing a fixed-rate loan:
- You are safe from rising interest rates:
If you take out a long-term loan, such as 10-15 years, interest rates will most likely increase during the entirety of your loan term. Choosing a fixed-rate loan will guard you against those potential interest rate increases.
- A fixed-rate loan offers predictable monthly payments:
Since the interest rate is fixed, this means your monthly payments will remain the same throughout your loan term. It will be much easier for you to determine the loan’s affordability in relation to your budget. Moreover, there will be no surprise payment that will make it challenging for you to repay the loan in the future.
- Choosing a fixed-rate loan means you will know the loan’s total cost upfront:
You will know the loan amount, loan term, and interest rate upfront. This means it will be effortless to know the total cost plus interest you will pay for the rest of the loan term.
Fixed-Rate Loan Drawbacks
Below are some of the drawbacks a fixed-rate loan carries:
- The monthly payment and interest rate will typically start out higher than a variable rate loan’s starting rate:
This means you will pay a higher amount upfront when it comes to fixed-rate loans rather than variable rate loans. Moreover, you could miss the chance of paying in lesser amounts at a lower monthly interest rate.
- Your interest rate won’t go down if the interest rate environment falls:
Although this is a disadvantage, there’s no need to worry because you can always choose to refinance your loan. That way, you can have the chance to enjoy lower interest rates.
Popular Types of Fixed Rate Loans
The following are popular types of fixed-rate loans you should know about:
An auto loan is a fixed rate type of loan that requires a borrower to pay a fixed monthly payment with interest at a set period. If you plan to take out an auto loan, the lender will require you to pledge the vehicle you will buy as collateral. Moreover, an auto loan usually comes with principal and interest periodic payments and a downpayment as well.
Suppose you plan to borrow $30,000 to buy a car at an interest rate of 10% payable over two years. You will have to pay a periodic payment of $1,375 for the entire loan term. However, if you make a downpayment worth $10,000, you will end up paying $958.33 instead.
A mortgage is also a type of fixed-rate loan. It helps borrowers purchase a real estate or property they have wanted to acquire. When it comes to mortgage, the lender will agree to release funds upfront in exchange for monthly payments over a set period. The borrower then uses the money to buy a property that will also be used as collateral until the loan term ends.
For example, one of the common types of a fixed-rate loan is a 30-year mortgage. This type of debt is payable for 30 years that comes with a fixed monthly payment. The said payments are made towards the interest and the principal.
What Are Variable Rate Loans and How Do They Work?
When it comes to variable-rate loans, the interest rates are prone to changes based on the market interest rates. Most of the time, lenders opt to follow a certain financial index to track interest rate changes. If the index shows changes, the lender will match those changes to your loan’s current interest rates.
Generally, variable rate loans usually have lower interest rates than fixed-rate loans because this option is riskier for borrowers. An increase in the financial index will automatically affect your current interest rate. Those who choose variable rate loans should expect a potential increase in loan costs. Moreover, you can find variable interest rates in personal loans, credit cards, mortgages, corporate bonds, and derivatives.
Variable Rate Loan Benefits
The following are benefits a variable rate loan can offer:
- You will most likely have a lower starting interest rate:
Choosing a variable rate loan means you get to enjoy a lower starting interest rate. If not, it would help if you look for a better lender.
In some cases, the low introductory rate is locked in for a couple of months or even years. If you plan to repay the loan in full before the introductory rate expires, a variable rate loan is indeed the right choice. That way, you will end up paying less in interest and more on the principal.
- You will most likely have a lower starting monthly payment:
Since you get lower interest rates at first, this also means you will have lower monthly payments. Lower compared to fixed-rate loans with the same loan term. This can even help you afford a loan that might seem impossible to reach. If you think your income has the potential of increasing during the loan term and you can afford higher monthly payments, then taking out a variable rate loan would absolutely make sense.
- There is a chance that your current interest rate will go down:
Since a variable rate loan is linked to a certain financial index, there is a chance that your interest rate will fall.
Variable Rate Loan Drawbacks
Below are the disadvantages of choosing a variable rate loan:
- There might be a potential increase in your payments:
If market interest rates go up, your payments will rise too. It would be best to know the maximum payment you could end up facing when you choose to get a variable rate loan. If the projected maximum payment is not affordable, you are taking a big risk. You could end up defaulting and negatively impacting your credit score.
- You might get stuck with the loan:
Some borrowers who plan to pay the loan in full earlier while the interest rates are down or those who plan to refinance when the rates are up will find some instances that prevent them from doing so.
You might lose your job, won’t be able to pay extra than what you expected to do, or don’t have enough income to qualify in refinancing the loan. This could leave you in a variable rate loan that is challenging to get out of since it can become expensive.
- It will be challenging to plan with certainty:
It would be difficult for you to plan your budget. This is because your interest rate and total loan cost might change during the life of the loan. Furthermore, it would help if you make sure you know how many times your loan could adjust. The more it adjusts, the greater the risks and uncertainty.
Making a Choice
The interest rates on a fixed-rate loan will remain the same throughout the life of the loan. On the other hand, a variable rate loan is greatly influenced by a certain financial index a lender chooses. Furthermore, both loan types’ interest rate status will also affect the total loan cost you will end up paying.
Choosing between the fixed rate and variable rate loans can be quite challenging. This is because both have significant benefits and drawbacks. To help you make a decision, it would be best to consider your budget, risk tolerance, and what your loan’s total cost would end up being.
Editor’s note: This is a paid article.