Fixed vs variable interest rates: Which one is right for you?

Are you planning to take out a loan? Choosing between fixed vs variable interest rates can make a huge difference over the life of your loan. Fixed interest offers stability while variable interest changes over time.

To guide you, we explore the differences between fixed and variable rates, the pros and cons, and how to choose which one is better.

Key takeaways

• A fixed-rate loan has a rate that doesn’t change over the loan term while a variable-rate loan fluctuates periodically.
• A fixed-interest rate loan is ideal if you want security and stable payments since your rate is locked in.
• A variable interest rate loan can reduce your payments when the interest rates decline.
• Fixed and variable rates are available for several loan products, such as mortgages, student loans, and personal loans.

Fixed interest rate loans

As the name suggests, a fixed interest rate remains the same. That said, your monthly payments also stay the same over the life of the loan. Let’s say you take out a 36-month fixed personal loan with a rate of 14.99%. This means your interest rate will carry on being 14.99% for 36 months.

Fixed-interest loans offer security and peace of mind — making them popular with those who prefer stability. Since you know how much you need to pay each month, budgeting becomes a lot easier. And it’s also a good option if the interest rates are likely to go up based on the economy.

Different types of loans can be fixed rates, whether they are personal loans, mortgages, auto loans, or student loans. But keep in mind that each type has its own interest rate and terms.

How does a fixed rate work?

When you choose a fixed rate, your interest stays the same regardless of the market. For example, consider a 12.99% fixed rate. Then, after six months, the average fixed rate climbs to 13.99%.

Though the current market rate increases by one percent, this doesn’t affect your interest. So, you end up saving more money in the long run. On the flip side, if the average fixed rate declines by one percent to 11.99%, you miss out.

Essentially, this doesn’t change your loan payments. Meaning if you pay $68 per month, market fluctuations don’t impact how much you pay.

In general, the better your credit, the lower rates you may qualify for. But a variety of factors influences your fixed interest rate loan. Lenders and credit unions, for instance, evaluate your credit history, credit score, income, and employment.

Pros and cons of fixed interest rates

Benefits of a fixed rate

• Protection against rising interest rates: A fixed-rate loan protects you from unexpected rate increases. This, in turn, can give you peace of mind throughout your loan term.
• Certainty: Along with peace of mind, a fixed rate is more stable and less risky. That being said, you can be certain of your payments for the entire repayment period.
• Predictability: You also know what your monthly payments cost you. With this, you can budget easier and better plan your finance.

Risks of a fixed rate

• Lack of benefits from falling interest rates: Since you have the same interest rate for the term, you won’t benefit from falling interest rates. This means you may potentially miss out on saving money if the Federal Reserve drops the rates.
• Additional fees: Some fixed loan rates come with additional fees, including prepayment penalties and exit fees. If ever you decide to refinance, these fees can increase the total cost of your loan.
• Higher interest rates: Fixed interest rate loans may also be higher than variable interest rate loans. So, you may end up paying more interest overall.

When to choose a fixed-rate loan

Choosing a fixed-rate loan can help you be certain of your monthly payments. Let’s say you are concerned about rising interest rates; a fixed rate may be your best bet to ease this worry. This option protects you from unexpected rate spikes that may throw off your budget.

Also, if you like to carefully plan your budget, a fixed rate can help you. Considering your payments are fixed, you know exactly how much you need to set aside for each month. This, in turn, sets clear expectations of your expenses and savings.

It’s also ideal to lock in your rate for a short period if the interest rates are ultra-low. If you have a short-term loan, taking advantage of a low fixed rate can help you save on interest.

Variable interest rate loans

Unlike fixed interest, variable interest rates fluctuate over time. For example, you take out a 60-month loan with an 11.99% variable rate. Depending on the market, your interest can increase or decrease over the life of your loan. This means your monthly payments also change.

Variable rates give you flexibility in taking advantage of lower interest rates if the market goes down. Taking the example above, if the rate drops by one percent, 11.99% would fall to 10.99%. But there is also the risk of rates increasing — for example from 11.99% to 12.99%. In turn, your monthly payments can also increase.

How does a variable rate work?

Two major aspects can affect your variable rate:

• Index: The index acts as the benchmark rate that soars and plunges based on market conditions. Banks use a benchmark rate, usually the prime rate or LIBOR (London Interbank Offered Rate). The prime rate is the lowest interest rate that commercial banks offer to borrowers. Meanwhile, the LIBOR is the rate that banks charge one another when borrowing.
• Margin: Then, the margin reflects the percentage points that lenders add to your index. This is based on different factors, like your loan type and creditworthiness. So, the higher your credit, the lower your margin may be. Usually, the margin rate stays constant throughout your term.

Pros and cons of variable interest rates

Benefits of a variable rate

• Benefit from falling interest rates: You can take advantage of falling interest rates. This, in effect, lowers your monthly payment, too.
• Lower initial interest rates: Variable loans often have lower initial interest rates than fixed loans. With this, you can save more at the start of your loan term.
• Lower interest rates: Typically, variable interest rates are lower than fixed interest rates. That said, you may save more overall.

Risks of a variable rate

• Risks of rising interest rates: Your variable rate increases if the interest rate rises. As a result, your monthly payment goes higher.
• Uncertainty: Because variable rates can change over time, they make it quite difficult to plan your future loan payments. This can then strain your budget.
• Difficulty in budgeting: Fluctuating monthly payments can also make budgeting more challenging. For one, you need to adjust your budget to consider the changing interest rates.

When to choose a variable rate loan

Variable-rate loans can be ideal if interest rates are inclined to fall or remain low. Let’s say the current market suggests that rates may drop or stay down. Considering this, you may benefit from variable interest. This then will lessen your interest rate and monthly loan payments.

Also, if you plan to refinance or pay off the loan early, a variable interest rate may be a good choice. Lenders and banks often offer reduced initial interest rates. With this option, you can benefit from lower introductory rates on variable loans, which lowers your payments.

What is better: Variable or fixed interest rate?

Whether a fixed or a variable rate is better boils down to your preferences and case. But there are some factors you can keep in mind when picking between the two.

• Market conditions: If experts predict a spike in interest rates, locking in a fixed rate for a short term can give you that added security. On the other side of the coin, if there’s a good chance rates may drop, a variable rate can give you some flexibility.
• Your preferences: If you’re the type who prefers security, a fixed-interest rate loan also makes more sense. This helps you plan your budget with confidence. But if you’re someone who favors the flexibility of fluctuating interest, then a variable interest is for you.
• Your financial situation: Factors like job stability, your current salary, and your savings can also all come into play. Let’s say you have a stable job with a potential salary increase down the road. In that case, the benefits of a variable rate may override the risks.

Student loans

Fixed student loan

Fixed-rate student loans help students cover the costs of education. In a nutshell, a fixed student loan’s rate stays constant throughout the life of the loan. This generally makes fixed student loans a safer choice compared to variable rates. Take note that new federal student loans have fixed rates.

Here’s how they work: When you take out a fixed-rate student loan, the interest rate doesn’t change. That being said, your monthly payments and overall loan stay the same. This then gives you a level of certainty since you know exactly how much you need to repay each month. As a result, budgeting and financial planning can be easier.

It’s particularly beneficial if you expect interest rates to rise. Also, if you don’t want to risk a student loan going higher, a fixed rate protects you. In case you’re in a low-interest environment, fixing your loan to a low rate helps you save more.

Variable student loan

Variable-rate student loans have a different approach compared to fixed rates. When the prime rate or LIBOR changes, your loan’s interest rate also increases or decreases. Private student loans are usually variable rates, but federal student loans are only fixed.

Imagine a scenario where interest rates are ultra low — you can enjoy lower monthly payments and some financial relief. Remember though that if interest rates go up, your monthly payment also rises.

Variable student loans can be great if the market conditions are looking good. In this case, a variable rate loan can help you save some money. Also, if you have plans to pay off your student loan earlier, you can benefit from a variable rate.

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