Fixed vs. Variable Interest Rates: What's the Difference?
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 depending on the market. Borrowers who prefer predictable payments generally prefer fixed rate loans, which won't change in cost.
What is a fixed rate loan?
Interest rates on fixed rate loans stay the same for the loan's entire repayment term. This means 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, auto loan or student loan, a fixed rate allows the borrower to have standardized monthly payments.
One of the most popular types of 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 loan pros and cons
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Cons
What is a variable rate loan?
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 also available with a variable rate, such as private student loans and mortgages.
Auto and personal loans are typically only available with a fixed rate, although some lenders offer a variable rate option.
One of the most popular loans in this category is the 5/1 adjustable-rate mortgage (ARM), which has a fixed rate for five years and then adjusts every year after that.
In general, variable rate loans tend to have lower interest rates (at first) 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, variable rate loans are a good option for consumers who can afford to take the risk or who plan to pay their loan off quickly.
How variable rate loans work
Variable-rate consumer loans have been tied to two benchmark rates, the London Interbank Offered Rate (LIBOR) or the prime rate.
While LIBOR was one of the benchmarks as of publication, it will be phased out by June 2023, according to the Consumer Financial Protection Bureau (CFPB).
LIBOR may be replaced with Secured Overnight Financing Rate (SOFR)-based indexes, which experts have recommended.
These benchmarks serve as an easy way for financial institutions to determine the price of money.
Lenders use these indexes as baselines for variable rate loans, adding a margin on top of the benchmark rate to calculate the rate received by a consumer.
The margin used on variable interest rates is the percentage points added after the initial rate period finishes, and it won't change after the loan is closed.
As with other forms of debt, the margin and interest rate that a borrower receives on a variable rate loan are heavily dependent on their credit score, lender and loan product.
For example, 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.
What are 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 unpredictability of the markets. For this reason, fixed rate loans can best guarantee long-term affordability in a low interest rate environment.
For most adjustable-rate mortgages, the interest rate cap structure is broken down into three separate caps:
- The initial cap determines the maximum amount the rate can initially change.
- The periodic cap sets the amount the rate can change during each adjustment period.
- The lifetime cap determines how high the rate can go.
Variable rate loan pros and cons
Pros
Cons
Variable vs. fixed rate loan: Which is better?
When taking out a loan, you may wonder which is better for you: variable or fixed interest rates.
Before taking out a loan, it's most important to consider your personal financial situation and the specifics of each loan. These factors can help you decide whether to choose a fixed or variable rate option.
Remember that the interest rate is only one part of the total cost of a loan. You’ll also want to consider other factors that contribute to the loan’s affordability:
- Term lengths can play a role in determining how much you pay over the lifetime of a loan. For example, the longer your repayment term is, the more you may have to pay in interest, though your monthly payments may be lower. Likewise, the shorter your term length is, the higher your monthly payments may be but the less you may have to pay in interest.
- Lender fees can drive up the total cost of a loan. For instance, some personal loan lenders charge origination fees — a type of administrative fee that comes out of the total balance of your loan. Mortgage lenders may charge an assortment of fees, such as origination charges, application fees and underwriting fees.
- Expected income can determine a borrower’s ability to repay a loan, so it’s important to decide ahead of time whether a loan is affordable in the long term. This analysis could include potential raises and promotions, a change in jobs and even the potential to lose one's job.
Student loans
If eligible for a federal student loan, choosing the fixed rate option is best for those with little credit history or bad credit scores.
All federal rates are predetermined by the government, and unlike on private loans, the rates 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.
Most student borrowers generally 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 refinancing.
Mortgages
Mortgage interest rates fluctuate constantly, making it important for homebuyers to pay attention to market conditions.
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 initial 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 would have been 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 30 years.
Frequently asked questions
When you take out a loan with a variable rate, you’ll take on the risk that your interest rates may go up. This is because your interest rates will be based on market conditions, which can be unpredictable.
Higher rates may make your loan payment more difficult to afford, which can lead to fees if you’re unable to keep up with the rising costs.
Changing your rates from fixed to variable isn’t common. But if you have a loan with a variable interest rate, some lenders may allow you to switch to a fixed interest rate instead. However, you may have to pay a fee to make that change, so be sure to check with your lender.
One of the benefits of having variable interest rates on a loan is that the market can shift in your favor, and interest rates can go down. This, in turn, will cause your monthly payment to go down. Interest rates typically go down when the federal government is working to stimulate the economy and encourage borrowing.