Last Updated on March 2, 2024
Whether you want a mortgage, auto loan, payday loan, business, personal loan, or emergency loan, the amount you pay back is always higher due to the interest factor. Lenders advance credit facilities to borrowers and earn money through the interest charged.
If you decide to take a loan, at some point, you’ll be faced with the question; which interest rate model is right for you? Your lender may offer fixed and variable interest rates.
Whereas fixed rates remain the same during the loan tenure, variable interest rates change depending on the outstanding loan balance. This article offers in-depth insight into variable and fixed interest rates to help you decide the best option.
What is a Fixed Interest Loan
As the name suggests, a fixed interest rate loan has the same interest throughout the tenure of the loan. Indeed you’ll know the total cost of credit at the time of signing the loan agreement.
You’ll have other relevant data, such as the amount to pay each month, the cost of credit, which corresponds to the interest payable, and the interest rate.
How Does a Fixed Rate Loan Work?
As noted, a fixed rate interest rate does not change regardless of the duration of the loan.
Here is an illustration;
If you take out a 60-month $20,000 loan on a car at a fixed rate of 4%, your monthly installments will be;
4% multiplied by 20,000 to get an interest of $800 per year.
The total interest payable will be $4000.
The total loan plus interest is $24000.
Your monthly installment will be $400.
What Are The Pros of a Fixed Rate Loan?
A fixed-rate loan lets you plan your future cash usage and keep track of your budget. You know the amount you need to pay monthly regardless of the current market situation.
The advantage of fixed interest rates is that they remain constant during inflation and other market crises.
What Are The Cons of a Fixed Rate Loan?
The loan facility is not flexible with fixed interest rate loans since it remains the same during a loan duration. Fixed-rate loans may have additional fees imposed on the borrower should they want to terminate early.
Historically, fixed-rate loans have always been viewed as more expensive than variable interest loans.
What is a Variable Rate Loan
Here the interest rate may change throughout the loan tenure. It’s impossible to know the total cost of borrowing at the time.
The variable interest rate is subject to variations according to a reference, or benchmark interest is known as the Federal lending rate.
Generally, banks use note rates, LIBOR(London Interbank Offered Rate), prime rate, and multiple U.S. Treasury bills as benchmark indexes.
Therefore, the variable interest rate fluctuates depending on the base index. Nonetheless, the changes are not drastic but happen periodically, based on your agreement with the borrower.
How Does a Variable Rate Loan Work?
As noted, a variable interest is based on a reference rate such as LIBOR or prime. Generally, LIBOR is the rate at which banks borrow from each other.
The rate comes from data obtained from bank surveys and interest charged through peer-to-peer borrowing among institutions.
Monetary policies regulate the fed rate. On the other hand, the prime rate is mainly used as an index rate for mortgages, credit cards, and auto loans.
It depends on the Federal Reserve funds rate, the rate charged for overnight borrowing to fulfill the federal reserve funding requirements.
Lending institutions use the prime rate and LIBOR as the starting points for setting interest rates. Normally, you’ll be charged a margin or a spread above the reference rate.
It’s important to know that the margin depends on multiple factors, such as your risk level or credit rating, type of asset, and loan duration.
The total of the benchmark rate and the spread are equal to the variable interest rate.
For instance;
Suppose you apply for an auto loan and the lender charges a prime rate+2.5%;
2.5% is the margin or the profit to the bank.
Your lender applies the base rate plus the margin for a hybrid mortgage loan. In this case, the adjustable rate incorporates variable and fixed interest rates.
You may pay a fixed rate for a certain period, and then the variable interest is reset every year depending on the benchmarked rate.
What are the Pros of Variable Interest Rate Loans?
For a borrower, a variable rate loan is the best option because the interest rate changes depending on the loan duration and the outstanding balance.
Normally, the interest rate is lower at the start of the loan payment and declines over time in the course of the loan duration.
But, when interest rates fluctuate due to federal reserve monetary policies to tackle inflation, fixed-rate loans become attractive.
The U.S. inflation increased to 9.1% by June 2022, so the Fed increased the interest rate by 0.75 percentage points to combat the high prices. Therefore this may impact the variable interest rate in the short term.
From a lender’s point of view, a variable rate is more attractive because it gives a higher value than a fixed-rate loan. The lending institution can change the rate depending on the market conditions.
For a mortgage loan, variable interest loan lenders structure the rate to include the reference rate and the spread.
If your credit score is exemplary, your lender may only apply the benchmark rate and charge you the interest depending on the market fluctuation.
For credit cards, the variable interest rate has an annual percentage rate (APR) pegged on a base rate like the prime rate.
What are The Cons Of Variable Interest Rates Loans?
Variable interest rates can be an eyesore when the prime rate goes up. If you hadn’t planned for such an eventuality, your cost of borrowing goes up, and you may have problems paying the loan.
Additionally, the variable interest rate is unpredictable, making it difficult to budget. Also, you may not be able to predict your future cash flows.
Can The Choice Between Fixed Rate vs. Variable Interest Rates Help Managing Personal Finances?
It’s worth noting that loans of any type profoundly impact your cash flows and ability to meet your future goals.
The choice between fixed and variable interest rate loans can make or break your current and future financial situations.
If the cost of borrowing is too high, you’ll have less money to save, which can affect your future ability to meet financial obligations.
If you struggle to pay your loans due to high-interest rates, you can be negatively listed on credit bureaus, affecting your future borrowing ability.
Variable or Fixed Interest Rate Loans: Which Way Forward?
Now that we understand the main differences between a fixed and variable rate interest loan, you can opt for one that will not complicate your financial situation and goals.
If you’re trying to choose between variable or fixed rate payday loans, you need to consider the duration of the loan.
A payday loan is a short-term loan facility usually paid by your next paycheck. The duration is too short; therefore, a fixed-rate interest loan will make sense in this situation.
As mentioned earlier, fixed-rate interest loans are viewed as more expensive and, therefore, would not be a good choice for a mortgage facility. Instead, you can opt for a hybrid interest rate.
From the lender’s perspective, determining the type of loan depends on your credit profile and market situation.
In a situation of decreasing fed rates, a variable interest rate loan is better. Still, the tradeoff would be the risk assessment should the market shift to higher interest.
Your main objective as a borrower is to mitigate the high cost of borrowing, and a fixed rate would be a better situation.
The parting shot is that macroeconomic circumstances determine the interest rates. Therefore before you sign the loan agreement, observe what’s happening in the country and worldwide.
Other Tips To Manage Your Personal Finances
You can incorporate the following tips for maintaining your financial health.
- Make a budget for your income and expenses to avoid impulse buying and debt accumulation.
- Pay your debts on time to avoid being listed negatively on credit reporting agencies.
- Have one credit card and maintain the 30% credit card utilization rule. It helps you not to exceed the borrowing limit.
- Consider debt consolidation if you have multiple loans.
- Pull a credit report at least twice a year to identify expenses impacting your score. Notably, some open accounts typically have extra monthly charges; if you fail to notice these, they may affect your overall credit score.
- Have reminders for utility bill payments.
- Save a portion of your income every month. It’s never too late!
Conclusion
No interest rate works well for all borrowers. Some people prefer a variable interest rate, while others favor a fixed interest rate. It’s important to keep in mind the risks and advantages of each method before you apply for a loan.
