A fixed rate loan has the same interest rate for the entirety of the borrowing period, while variable rate loans have an interest rate that changes over time. Borrowers who prefer predictable payments generally prefer fixed rate loans, which won't change in cost. The price of a variable rate loan will either increase or decrease over time, so borrowers who believe interest rates will decline tend to choose variable rate loans. In general, variable rate loans have lower interest rates and can be used for affordable short term financing.
- What is a Fixed Rate Loan?
- What is a Variable Rate Loan?
- Should You Choose a Fixed or Variable Rate Loan?
Fixed Rate Loans Explained
On fixed rate loans, interest rates stay the same for the entirety of the loan's term. This means that the cost of borrowing money stays constant throughout the life of the loan and won't change with fluctuations in the market. For an installment loan like a mortgage, car loan or personal loan, a fixed rate allows the borrower to have standardized monthly payments.
One of the most popular fixed rate loans is the 30 year fixed rate mortgage. Many homeowners choose the fixed rate option because it allows them to plan and budget for their payments. This is especially helpful for consumers who have stable but tight finances, as it protects them against the possibility of rising interest rates that could otherwise increase the cost of their loan.
- Fixed rate loans have interest rates that stay the same for the life of the loan
- Consumers who value predictability tend to prefer fixed rate loans
Variable Rate Loans
A variable rate loan has an interest rate that adjusts over time in response to changes in the market. Many fixed rate consumer loans are available are also available with a variable rate, such as private student loans, mortgages and personal loans. Auto loans are usually only available with a fixed rate, although specialized lenders and banks outside of the U.S. sometimes offer a variable rate option. One of the most popular loans in this category is the 5/1 adjustable-rate mortgage, which has a fixed rate for 5 years and then adjusts every year.
In general, variable rate loans tend to have lower interest rates than fixed versions, in part because they are a riskier choice for consumers. Rising interest rates can greatly increase the cost of borrowing, and consumers who choose variable rate loans should be aware of the potential for elevated loan costs. However, for consumers who can afford to take risk, or who plan to pay their loan off quickly, variable rate loans are a good option.
|Loan Type||Typical Fixed Rate||Typical Variable Rate|
|30 Year Mortgage||4.15%||3.60% (5/1 ARM)|
|Private Student Loan||6.65%||4.75%|
How Variable Rate Loans Work
Most variable rate consumer loans are tied to one of two benchmark rates, the London Interbank Offered Rate, known as LIBOR, or the Prime Rate. Most simply, these two benchmarks serve as an easy way for financial institutions to determine the price of money. Lenders use LIBOR and the Prime Rate as baselines for variable rate loans, adding a margin on top of the benchmark rate to calculate the rate received by a consumer.
As with other forms of debt, the margin and interest rate that a borrower receives on a variable rate loan are heavily dependent on credit score, lender and loan product. For example, credit card companies tend to use the Prime Rate listed in the Wall Street Journal at the end of each month to determine interest rates a consumer receives in the next month. With a Prime Rate of 4.25% and an added margin of 7% to 20%, a consumer with good credit might have a 10% margin added—receiving an interest rate of 14.25%. Margins tend to be higher for riskier loans, less creditworthy borrowers, and shorter term loans.
Interest Rate Caps
Due to the risk of benchmark rates rising to extremely high levels, most variable rates have ceilings which can help protect borrowers. However, the caps themselves are often set at high levels and can't protect against the unpredictably of the markets. For this reason, fixed rate loans can best guarantee long term affordability in a low interest rate environment. Consider how the lowest available fixed rate on a 7 year personal loan from the online lender SoFi is 7.95%, while the interest rate cap is set at 14.95%—nearly twice the fixed version.
For most adjustable-rate mortgages, the interest rate cap structure is broken down into three separate caps, where the initial cap determines the maximum amount the rate can initially change; the periodic cap sets the amount a rate can change during each adjustment period; and the lifetime cap determines how high a rate can go.
Rate Cap Structure on a 5/1 ARM with Initial 3.75% Interest Rate
- Initial cap of 1.5%: The rate can go as high as 5.25% or as low as 2.25% during first adjustment period
- Periodic cap of 2%: If rate rose to 5.25% during first period, the rate can go as high as 7.25% or as low as 3.25% during the second period—in subsequent periods the rate can adjust by as much as 2% from the previous period's rate
- Lifetime cap of 10%: The rate can only go as high as 13.75%
Choosing Between a Fixed and Variable Rate Loan
Before taking out a loan, it's most important to consider your personal financial situation and the specifics of each loan. Looking at these factors first can help you decide whether to choose a fixed or variable rate option. You should also remember that interest rate is only one part of the total cost of a loan. Other factors like term length, lender fees and servicing costs will also contribute to the overall expense.
If eligible for a government loan, choosing the federal fixed rate option is best for those who have little credit history or a bad credit score. All federal rates are predetermined by the government and, unlike other loans, they aren't adjusted based on each borrower's personal financial situation. In contrast, a variable rate loan can help secure a lower rate for student borrowers with good credit, or for those seeking to refinance.
In general, most student borrowers finance their education with federal loans, which only come with fixed rates. However, variable rate loans are available for those who are choosing between private and federal loans, or who are considering a refinancing.
Interest rates for mortgages remain near historical lows, so locking into a 30 year fixed rate mortgage will secure affordable repayments. However, a prospective homebuyer looking to sell their house or refinance their mortgage after a few years could benefit from an adjustable-rate mortgage—as their lower rates make them more affordable in the short term.
In this case, it's most important to determine the length of time you plan to have a mortgage. Once the rate starts adjusting on an ARM, it will likely exceed the rate you'd be able to lock in with a fixed version. And on such a long term debt obligation, the difference of 0.25% or 0.50% on an interest rate can mean tens of thousands of dollars over the course of 30 years.
As discussed above, fixed rate personal loans are generally a good option for those who favor predictable payments through the long term. Fixed-rate loans can also help secure an affordable long term payment on a 7 or 10 year loan. On the other hand, variable rate loans can be an affordable way to quickly pay off debt or secure a lower payment in the future if rates decline.
As with mortgages and private student loans, it's important to remember that factors like credit score and debt-to-income ratio are most likely to determine the interest rate you receive. To receive the lowest interest rate, you should monitor your finances, keep a low debt-to-income ratio and aim to build your FICO credit score.