Fixed and Variable Rate Loans: Which Is Better?

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. 

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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 

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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]

Check Your Personal Loan Rates

Answer a few questions to see which personal loans you pre-qualify for. It’s quick and easy, and it will not impact your credit score.

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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What Is Mortgage Recasting and How It Can Save You Money

If you are eager for a way to save money on your mortgage, one popular option is through mortgage recasting, or when a large payment allows you to re-amortize your mortgage and reduce your monthly payments. Here, we go through the pros and cons to recasting a mortgage.

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What is mortgage recasting?

Mortgage recasting, also known as mortgage re-amortization, is when a borrower makes a lump sum payment toward their home loan balance. The lender re-amortizes the loan, and the borrower’s monthly payments are adjusted, though the interest rate and loan term stay the same.

Recasting saves borrowers money in two different ways. First, re-amortizing the loan based on the new principal balance reduces a borrower’s monthly payments. The homeowner will also save money on interest over the course of their loan since there’s a lower balance to accrue interest on.

Many lenders allow borrowers to recast their mortgages, including those purchased by Fannie Mae and Freddie Mac. However, government-backed loans such as FHA loans and VA loans aren’t eligible.

[ Read: Compare Today’s Best Mortgage Rates ]

How does mortgage recasting work?

Suppose a mortgage borrower had a current principal balance of $200,000 with a 30-year term and an interest rate of 3.5%. If they continue making their regular mortgage payments, they can expect monthly payments of about $898. By the time they pay off the full mortgage, they’ll have paid around $123,000 in interest.

But imagine instead that they spend $30,000 to recast their mortgage, bringing their new principal balance down to $170,000. Using the same 30-year term and 3.5% interest rate, their new monthly payments will be just $763 per month. And they’ll ultimately pay about $105,000 in interest, saving themselves about $18,000.

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Pros of mortgage recasting

Mortgage recasting can be an excellent way to help homeowners save money on their home loans. Similar to mortgage refinancing, it can help borrowers pay less money in interest. There are a handful of benefits to recasting and a couple of reasons why homeowners might prefer it over refinancing.

  • Lower monthly payments. Recasting your mortgage reduces your monthly payment because it takes a smaller principal balance and spreads it across the same loan term.
  • Less interest paid overall. Because of the new lower principal balance, mortgage recasting results in paying less interest over the course of the loan.
  • Fewer requirements than refinancing. Mortgage refinancing comes with many hoops to jump through, including an appraisal and qualifying for a new loan. Recasting is far simpler, and you don’t have to meet special financial requirements.
  • Less expensive than refinancing. When you refinance your mortgage, you have to pay a whole new set of closing costs. Mortgage recasting only comes with a small fee.

[ Read: Compare Today’s Best Mortgage Refinance Rates ]

Cons of mortgage recasting

Despite its perks, mortgage recasting isn’t right for everyone. In some cases, an alternative such as refinancing might be a better fit.

  • Mortgage recasting fee. When you recast your mortgage, you’ll have to pay a small fee, often around $250. While this is significantly less than the amount you’d pay in closing costs to refinance a mortgage, it’s still something to consider.
  • No reduced interest rate. When you refinance your mortgage, you often get the benefit of a lower mortgage interest rate, which can save you 10s or even hundreds of thousands over the life of the loan. Recasting doesn’t lower your interest rate — it only reduces the principal balance that accrues interest.
  • No shortened loan term. Mortgage recasting doesn’t shorten your loan term. If you had 20 years left on your loan, you still have 20 years left after recasting. However, your new lower monthly payment leaves more money available in your budget, so it may be easier to pay your mortgage off early.
  • Not available for all mortgages. Not everyone is eligible to recast their mortgage. Government-backed loans such as FHA loans and VA loans generally aren’t eligible. However, those mortgages are eligible for refinancing, so homeowners with those types of home loans may consider that instead.

Qualifying for mortgage recasting

Not everyone is eligible for a mortgage recasting. It’s best to talk to your lender about their requirements and find out whether you qualify. Here are some common requirements you’ll likely run into:

  • No government-backed loans: Government-backed loans such as FHA loans and VA loans aren’t eligible for mortgage recasting.
  • Recasting with your current lender: Not all lenders offer mortgage recasting. And unlike mortgage refinancing, you can’t simply recast with a different lender than the one that services your loan.
  • Recasting minimum: Many lenders require borrowers to make a minimum recasting payment. Lenders typically require that your payment is at least $5,000.
  • Equity and payment requirements: Some lenders may have requirements stating you must have a certain percentage of equity in your home or that you have made a certain number of on-time payments before recasting.
  • Recasting fee: Most lenders charge a small fee to recast your mortgage. The fee is typically around $250, meaning it’s a drop in the bucket compared to the lump sum payment you’ll make. But it’s important to be aware of and budget for this fee.

[ Read: Best Investment Property Mortgage Rates ]

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