Reading over your loan options can feel like studying a foreign language. What is a fixed vs. variable loan? And what on earth is a rate index? Whether you are taking out a home loan or financing your next vehicle, you’re bound to come across some of the same terms.
Having a fixed-rate loan is right for people who can lock in a low rate and have never been one for gambling. But that’s not to say that variable-rate loans don’t have their advantages. Let’s talk about the differences between these two loan types and what they can mean for your financial bottom line.
What is a fixed-rate loan vs. a variable-rate loan?
The main difference between a fixed-rate loan and a variable-rate loan is that your loan payment remains the same with a fixed rate and may fluctuate with a variable rate.
Let’s look at an example.
Imagine you get a mortgage with a 2.75% interest rate over 30 years. Your bank will calculate your monthly payment, and it will remain the same over the entire term of your loan. Now let’s say you’re offered a variable-rate loan at 2.5%. That sounds appealing, but as interest rates rise in the real estate market, your rate could go up. Within five years you might be paying closer to 3.25% interest and owe a few hundred dollars more each month.
|Fixed-Rate Loan||Variable-Rate Loan|
|Rates||Stay the same over the course of the loan||Fluctuate according to market conditions|
|Loan Amounts||Vary by type of loan||Vary by type of loan|
|Terms||Remain the same for up to 30 years, depending on the type of loan||Change based on market conditions, and may include a balloon payment at a designated time|
[ Read: Best Auto Loans ]
Understanding fixed-rate loans
What is a fixed loan? As mentioned above, a fixed-rate loan is one in which the consumer (that’s you) locks in an interest rate when they finalize their loan. That interest rate remains stable throughout the life of the loan unless you refinance.
Fixed-rate loans are popular when it comes to financing ranging from auto loans to mortgages to personal loans. They are ideal for the risk averse or anyone who is lucky enough to be financing when rates are at historic lows. Many businesses also opt for a fixed-rate business loan because reliable loan payments make it easier to forecast future expenses and create profit goals.
However, on the downside, a person locked into a fixed-rate loan may end up paying a higher-than-average interest rate if the market rates drop. For instance, a consumer who obtained a 48-month auto loan in the first quarter of 2020 would have likely been offered a 5.29 percent interest rate (based on average rates from commercial banks). A few months later, the average rate for the same loan had dropped to 5.13%. If locked into a fixed-rate loan, this consumer would be paying more per month than someone who got a loan in the following quarter.
Understanding variable-rate loans
What is a variable loan? One of the primary benefits of a variable-rate loan is that the initial interest rate is often lower than what you’re offered for fixed-rate loans. This can be appealing for consumers who are on a tight budget. However, variable-rate loans don’t remain stagnant.
Most variable-rate loans fluctuate based on something called the prime rate. The prime rate may also be called the base rate. This rate is determined by individual banks, but influenced by the federal funds rate (this is the rate banks charge each other for short-term loans).The Fed, short for The Federal Reserve System analyzes current economic conditions eight times throughout the year and adjusts the federal funds rate accordingly. As the federal fund rate rises or falls, so typically does the prime rate that directly affects variable-rate loans.
You may be offered variable-rate loans for a variety of funding, but usually these loans apply to long-term loans. Student loans and home loans are the most likely to offer adjustable rates. Home loans may have a fixed rate for a set period initially (often five years) at which point the rate is subject to change. After the housing bubble burst in 2008, only 10-15% of buyers chose a variable-rate mortgage between 2008 and 2014, despite the fact that historically up to 30% of buyers had opted for an adjustable rate.
What are interest rate caps?
If you choose a variable-rate loan, your lender will outline the interest rate caps as a part of the loan terms. You can think of these caps as ceilings on the interest rate. An interest rate cap can affect how high your rate is able to rise, or how many points it can increase at once.
There are three main types of interest rate caps. The initial adjustment cap affects how much your interest can increase when the fixed-rate period ends. Often, this cap says that your interest rate can’t go up by more than a few percentage points when the fixed term ends.
After this initial period, you may also have a subsequent adjustment cap. This outlines how many points your interest can increase at once for every future period.
Finally, there is a lifetime interest cap. This is the rule that spells out how much your interest rate can increase over the initial rate for the entire loan. For instance, your lender may agree to never increase your interest rate to more than 5% over your original interest rate. If you paid 2.75% at the start of your loan, your interest rate would never be above 7.75%.
[ Read: Best Personal Loan Rates for 2021]
Should I get a fixed-rate or a variable loan?
Whether you should get a fixed-rate or variable-rate loan depends on a variety of factors. If you’re on the fence, consider these insights as you navigate the loan application process.
|Loan Type||Fixed Rate Loan||Variable Rate Loan|
|Personal||Good for consumers with good credit who can access low rates||Good for short-term loans when the rate doesn’t have much chance to fluctuate drastically|
|Student||Best when variable rates are high and a precise budget is a priority||Best when fixed rates are currently high and are likely to drop|
|Mortgage||Ideal for buyers who are planning to stay in the home for the long term||Only works for buyers who can handle a higher payment than they currently pay|
|Business||Great for small businesses who need a reliable budget in order to make ends meet||Great for thriving businesses who believe interest rates will drop and can get approved for a refinance if rates increase|
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