If you have ever taken a loan, or were interested in this topic, then you probably heard about loans with different types of interest rates that lenders offer. These are the two main types: fixed and variable rate loans.
A fixed interest rate has the same interest throughout the entire borrowing period, while a variable rate loans have an interest rate that changes over time. This may depend on many factors, so the first thing you need to know is that borrowers who prefer predictable payments every month should opt for loans with a fixed rate that will not change in value.
On the other hand, the price of a loan with a variable rate may change over time, so borrowers who believe that the interest rate can be reduced for any of the reasons that we will consider below can choose this type of the interest rate. In this case, you probably should choose loan with a floating rate. Such variable rate loans can often have lower interest at the start and are usually used for short-term financing.
If you are interested in what type of loan will be more profitable for you, then you should find out how fixed and variable rate loans can differ so that you can make the right choice for yourself. To be able to save your money, read on to understand this issue.
Fixed rate loans
As we mentioned above, loans with a fixed interest rate remain unchanged throughout the term of the loan. This means that market fluctuations, as well as your financial circumstances, will not affect the cost of borrowing money from the lender and the price remains constant throughout the life of the loan.
This option is best suited for a long-term installment loans, such as a mortgage, car loan, or a personal loan for any needs. Every month you will be sure of the amount of your next payment, which will allow you to plan your finances for many months and years ahead.
These circumstances make fixed rate loans most popular when it comes to mortgages for 20 or 30 years. They are especially popular among those borrowers who have a limited but fairly high stable income. This saves them from the risk of raising interest rates and appreciating their credit, which does not endanger their finances.
The variable interest rate may change over time, depending on what is happening in the market, as well as your creditworthiness. Variable rate loans are becoming a very popular choice for consumers when they deal with a 5/1 mortgage, which has a fixed interest rate for the first 5 years, and then it is adjusted annually.
Also, many consumer types of fixed-rate loans are available at variable interest rates. It can be not only 5/1 mortgage, but also auto loans, student loans offered by private lenders and others. In general, such loans often have lower interest, although they have more risks than loans with a fixed interest rates. Due to lower rates and despite the risks, when it comes to choosing between fixed and variable rate loans, many consumers are inclined with floating interest rates.
At the same time, we should not forget that variable interest rates may also increase, so they are most suitable for short-term loans when you are confident in your financial capabilities.
What determines floating rate loan interest?
To determine the floating interest rate, lenders use one of two base rates, which are tied to the so-called Prime Rate or LIBOR (London Interbank Rate), which are used in most cases to determine the level of interest in consumer loans. LIBOR is by far the most influential base rate in the world that banks charge each other for Eurodollars on the London interbank market.
The Federal Reserve is not the only place where most mid-sized and small banks can take out short-term loans, while getting an acceptable competitive price for money to borrow federal funds to meet their needs. Banks take deposits in US dollars in foreign banks, which are called Eurodollars.
Since interbank transactions are large enough, for banks even a small difference in the interest rate is so significant as to go abroad for them and be able to earn money. These interest rates in the interbank market serve for financial institutions as an easy way to determine the price of money.
Thus, by adding margin to the base rate, lenders use LIBOR and Prime Rate as basic benchmarks that determine the floating interest rate received by the consumer.
Also, except for rates in the interbank market, if a consumer chooses a variable rate option between fixed and variable rate loans, the level of interest rate for him will determine the level of his credit rating, the type of loan and the specific lender, as well as the margin he intends to receive. Most often, the margin will be higher in cases of short-term loans, for less creditworthy borrowers or riskier loans.
Marginal interest rates
Due to the fact that the market phenomenon is highly unpredictable, at the legislative level of most states, upper levels of marginal increase in variable interest rates were set to protect consumers.
At the same time, the upper limits do not help protect borrowers when the market starts its own rally. Due to the fact that the restrictions themselves are high enough, no one can guarantee you that you will not go beyond a certain budget when taking a loan with a variable rate.
Fixed and variable rate loans offer different risks and different guarantees, but when it comes to long-term loans without significant shocks, in this case you should pay more attention to fixed rate loans at as it possible low interest rates.
Choosing between fixed and variable rate loans
In any case, when you are going to take a loan, regardless of its type and other features, you should make a carefully considered decision based on all factors. Initially, determine the amount and duration of the loan that you need, and then consider the various loan options that may be available to you in your circumstances. Assess your financial capabilities and the stability of your position before deciding which type of interest rate will suit you best.
Fixed or variable student loan
Fixed interest rates are usually the best option for student loans, since the interest rate is fixed from the time a contract is entered into with the lender and remains at the same level until you repay your student loan in full or until you refinance it. Such interest rates will not depend on market fluctuations, as is the case with variable rates, which may change every month.
If you are considering taking out a private student loan, first use the available federal student loan programs that have fixed interest rates, as well as various additional options and subsidies that you will not find from private lenders.
While you are not sure exactly which of the options for fixed and variable rate loans will be most suitable for you, choose a safer option for a student loan with a fixed interest rate.
Variants of student loans with variable or floating interest rates are suitable for those who are going to quickly repay a student loan and understand how he will do it. If you fail to do it as quickly as you thought, then the interest rate may increase significantly over time, and you may have to pay a few thousand dollars more as a result.
The disadvantages of fixed interest rates include the fact that their level is usually at the very beginning higher than the one at which variable interest rates on student loans start. Also in the case of lower base rates, the flat rate will not be reduced and you will not be able to save on this.
If you decide to use a loan with a variable rate, then ask your lender what limit the interest rate of the student loans is set, as well as how often the interest can be adjusted.
Among the shortcomings of variable interest rates, one can single out the uncertainty that is always present in the market due to its fluctuations. Despite the fact that at the start of variable interest rates most often lower than fixed, in the next month or quarter, the situation may change and you will have to pay more.
If you have a short or absent credit history or bad credit, then you should turn to federal student loans that do not adjust interest rate depending on your credit rating or a change in your ratio of debt to credit limit.
Despite the fact that interest rates on mortgage loans are among the lowest, the amounts and terms of loans that are associated with them, do not allow borrowers to relax. Even the smallest rates grow by several tens of thousands of dollars in 20 or 30 years of mortgage. First of all, you should understand how much you can count on a monthly basis so that you can pay your monthly mortgage payment on time. If you have a limited, but stable monthly income, then in this case, you are probably more suited to a long-term loan with a fixed interest rate.
At the same time, when you have confidence in your financial capabilities or you are going to sell your old house, and letting money from its sale to pay off a mortgage to buy a new house, then a floating rate mortgage can be your choice. Paying off or refinancing a mortgage for a short period of time will allow you to use the low interest that are usually offered during variable rates.
When choosing between fixed and variable rate loans, in the case of a mortgage, you must accurately calculate how long you can repay the debt or refinance your mortgage. Since we are usually talking about a long term use of a mortgage loan, as well as large loan amounts, there is a change in the interest rate of even 0.5%, usually in the result that you pay a few thousand dollars more.
Personal loans with fixed and variable rates are usually much smaller amounts than mortgages, so they usually have much shorter terms. However, sometimes the term of a personal loan can reach 10 years, so if you need a longer option of fixed and variable rate loans, then you should prefer a fixed interest rate to have confidence in the amount of payment in each next month.
Personal loans with a variable interest rate, in turn, can help you save extra money in cases where you need a loan for a short period, you need a small amount of money, you are confident in your ability to pay such a loan quickly or you are sure that the interest rate can decline in the future.
Do not forget that your credit rating will directly affect the level of interest rates for you, especially when you are going to use a loan with a floating interest rate. If your loan condition deteriorates, the interest rate for you may increase, so make sure that your credit score does not fall.
Also, with your credit rating, the lender will periodically check your overall financial condition, your income, your use of an available credit limit, and other factors that may cause a change in the interest rate for you.
Now you know the difference between fixed and variable rate loans. The main differences are quite simple and it will not be difficult for you to decide which type of interest rate is right for you. In case of a long-term loan, loans with a fixed interest rate will often be safer for your finances, which ensure the stability of monthly payments.
At the same time, if you have the possibility to repay a loan in a short period of time or plan to refinance your debt in the near future, then it is worth considering the possibility of taking a variable rate loan in order to get an opportunity to save.
If you have a difficult situation and are not sure which type of interest rate will suit you better, then you can contact our financial experts for qualified assistance, just write to us.