People borrow money for many reasons. Whether it’s buying a car, paying for college, or purchasing a home, having debt can be scary, but it’s manageable — and maybe even beneficial — if you can afford the payments.
But it’s important you make the right choices when selecting the loan’s features or you could inadvertently get in over your head. One of the first decisions you have to make is whether you opt for a variable- or fixed-rate loan, which can impact your monthly payments and the total cost of the loan.
Before deciding, learn more about how each one works, its pros and cons, and when one is better than the other.
Variable-Rate Loans vs. Fixed-Rate Loans
In addition to your credit score, fixed- versus variable-rate loan types play the biggest role in the total cost of the loan. That’s why it’s crucial to understand how they work.
How Variable Interest-Rate Loans Work
Variable-rate loans have interest rates that can change over the life of the loan. Often, there’s an initial introductory period when the rate stays the same. After that, the rate can change on a set schedule, such as monthly, quarterly, or annually, as outlined in the contract. The loan contract can outline minimum or maximum rates as well.
Variable interest rates rely on a benchmark interest rate selected by the bank (which you can find in your contract). There are various types of interest rate benchmarks. Examples include U.S. Treasury bond yields, Libor (London Interbank Offered Rate), the federal funds rate, and the prime rate. Your interest rate is the benchmark plus a certain percentage, though that percentage varies based on your credit score.
Many variable-rate loans have schedules for rate adjustments. An adjustable-rate mortgage, for example,
For example, say the lender locks in the interest rate for the first five years, then adjusts it once per year every year thereafter. The adjusted interest rate is equal to the yield of a 10-year Treasury bond plus 0.50%. If the Treasury rate was 3%, you’d pay 3.5% for the first five years of the loan. On the fifth anniversary of getting your mortgage, the lender would adjust the rate. If the 10-year Treasury rate is now 5%, the rate would rise to 5.5%, which means your loan payments would rise. However, if the Treasury rate went down to 2%, your payments would go down because you’d now be paying a 2.5% interest rate.
Variable-rate loans involve unpredictability. You can’t know whether rates will change significantly or in which direction. However, those drawbacks come with some advantages inherent to the features of variable interest-rate loans.
- Low Initial Interest Rates. Typically, variable-rate loans offer lower initial interest rates than fixed-rate loans. That saves you a lot of money initially and can save you overall if you pay the loan off before the interest rate changes, assuming it goes up and there’s no significant prepayment penalty.
- Market Index Rate-Bound. Your loan contract specifies how the bank determines your interest rate, which it typically ties to a benchmark like Libor or Treasury notes. That doesn’t necessarily mean the rate is predictable, but it does mean loans are competitive and the rates aren’t arbitrary.
- Fluctuating Payments. Your monthly payments cover all accrued interest and a portion of the principal. That means changes to the interest rate change the monthly payment for better or worse.
- Rate Increases Capped. Your loan document details interest rate minimums and maximums. There can also be caps on how much the rate can increase during a single adjustment, helping you avoid huge swings in your monthly payments.
In home lending, loans that work like this are referred to as adjustable-rate mortgages.
How Fixed Interest-Rate Loans Work
Fixed-rate loans offer more certainty than variable-rate loans. When you get a fixed-rate loan, the interest rate never changes. That leaves you with a predictable monthly payment and overall loan cost.
Unlike variable-rate loans, there may not be a specific benchmark the rates track, but they generally move in tandem with the market. A major factor in determining interest rates for all types of loans is the federal funds rate, a benchmark interest rate set by the Federal Reserve based on the national economy.
Increasing the federal funds rate encourages banks to save money. In turn, banks charge higher rates for loans and decrease the supply of money in the economy. It’s a common tactic the Fed uses to cool an overheating economy or fight inflation.
By contrast, lowering the rate encourages more lending and reduces rates for consumer loans. That helps increase the money supply and speed up the economy.
As this major benchmark rate and other economic conditions change, the interest rate for newly issued fixed-rate loans will change. And while your credit score may play a role in how much interest the bank charges too, once you lock in the rate, it doesn’t change, even if the benchmark later does.
As with variable-rate loans, fixed-rate loans’ features may be positive for some borrowers and negative for others.
- Predictable Monthly Payments. With a fixed-rate loan, you can calculate exactly how much you’ll pay each month and the payment should not change over the life of the loan. That makes it easier to work a loan payment into your budget over time, especially if the loan term is a long one.
- Clear Total Cost Upfront. Because your monthly payments don’t change, you can calculate the total cost of a fixed-rate loan right away. Variable-rate loans don’t let you do that because you can’t predict changes in rates.
- Market Condition-Protected. When you get a fixed-rate loan, whether it’s for one year or thirty, your rate is locked in. It never changes, regardless of how the economy and market change. That’s awesome if rates rise but less optimal if they fall.
- May Be More Expensive Over Time. Fixed-rate loans tend to have higher rates than the initial rates on adjustable-rate loans, which can make them a bit more expensive, especially on short-term loans. If market interest rates hold steady or even drop, people with variable-rate loans will pay less than those with fixed-rate loans who are locked in at a higher cost. But even if they fall, they may have to fall quite a bit to make up for the lower initial rates on a variable-rate loan, depending on the term length and what the market does.
The Verdict: Should You Choose a Variable-Rate Loan or a Fixed-Rate Loan?
The choice between a fixed-rate loan and a variable-rate loan largely comes down to predictability and your own risk tolerance.
You Should Apply for a Variable-Rate Loan If…
Variable-rate loans are less expensive upfront but can be unpredictable. That makes them appealing to some borrowers. A variable-rate loan is best for you if:
- You Want a Short-Term Loan. In general, interest rates don’t move by large amounts over short periods. If you’re getting a short-term loan, the odds of massive increases in interest rates are relatively low, meaning you’re likely better off securing the lower rate. It’s even better if you can pay off the loan during its initial lower rate-lock period, though you should check for prepayment penalties before making any decisions.
- Your Budget Can Handle Varying Monthly Payments. When the interest rate of your loan changes, the monthly payment also changes. If you have flexibility in your budget and can accept fluctuating payments, a variable-rate loan might fit your goals.
- You Want an Overall Lower Cost of Borrowing. Unless market rates rise during the life of your loan, adjustable-rate loans usually have a lower overall cost of borrowing, though the longer the loan term, the more risk there is. For example, a five-year variable-rate home improvement loan is a safer bet than a 30-year variable-rate mortgage.
- You’re Willing to Refinance Later. Refinancing a loan lets you replace it with a new one. That means you can swap an adjustable loan for a fixed-rate loan if rates go up too much and your credit score allows.
- You Plan to Pay Off a Home Early. Adjustable-rate mortgages give you the chance to lock in the lower interest rate for the first five or more years of the loan and cap the annual rate increase. If you’re going to pay the loan off quickly, you can avoid the worst of the rate volatility. But check your contract for prepayment penalties.
- You Plan to Move in a Few Years. If it’s a mortgage and you plan to move in a few years, getting an adjustable rate with a rate-lock period for about the same amount of time you plan to live in the home means you benefit from the lower initial rate without the drawback of future rate adjustments.
You Should Apply for a Fixed-Rate Loan If…
Fixed-rate loans offer long-term predictability. They may be slightly more expensive at first but can be cheaper overall if market rates increase during the life of your loan. You should opt for a fixed-rate loan if:
- You Value Predictability. With a fixed-rate loan, your monthly payment never changes. That makes it easier to fit into your budget long-term.
- Benchmark Rates Are Low but About to Increase. If you have a feeling benchmark interest rates are about to rise, fixed-rate loans let you lock in a low interest rate without worrying about the interest rate market.
- You’re Paying for College. The federal government offers fixed-rate student loans to people going to college. Federal student loans usually have relatively low rates and offer great borrower protections, including income-based repayment and loan forgiveness options. Private student loans may have variable interest rates and are often more expensive.
- The Loan Term Is Long. If you buy a home and plan to live there for decades, locking in your interest rate can be a good idea. If rates drop, you can always refinance, but if rates rise and you have an adjustable-rate loan, you may only be able to refinance into a loan with a similar rate.
When you get a loan, choosing between fixed and variable rates is a big deal. Fixed rates usually win out if you plan to keep the loan for a long time or expect rates to rise, while variable-rate loans let you benefit from lower upfront costs and falling rates.
Take even more time to think about the impacts of this decision with long-term loans like mortgages. If you’re planning to buy a home, spend a lot of time considering the pros and cons of adjustable-rate mortgages before signing on the dotted line and only do so if you know you can pay it off faster than expected without a significant prepayment penalty.
Otherwise, rates are bound to increase at some point over a 30-year period. And consider the benefits of a 15-year versus 30-year mortgage in addition to variable versus fixed interest rates.