Understanding the Difference Between Fixed- and Variable-Rate Loans

While other topics may be dominating the news, financially savvy people are keeping a lookout for headlines about interest rates. In mid-December, policymakers at the Federal Reserve System (“the Fed”) will be meeting to determine if they will raise interest rates. While there’s currently a lot of speculation in the financial industry and no one has a crystal ball, it’s generally believed that even if the Fed doesn’t raise rates at the December meeting, it will eventually happen sometime in early 2016.

If you’re just catching up, interest rates have been at a historic low since 2008: The Fed dropped rates at the onset of the financial crisis and the Great Recession in the hope that it would help stimulate the economy. Now that the U.S. economy is getting stronger, many economists believe the time has come to raise interest rates.  

While a rise in interest rates would have far-reaching effects on many elements of the global economy, there’s one very specific way it could touch you: If you have a variable-rate student loan, auto loan, or mortgage, your monthly payments will likely go up. It also means that if you’re considering taking out a new loan or refinancing an existing one, and you’re unsure of the differences between variable- and fixed-rate loans, now is the time to learn. It will prepare you to make the best choice for your own finances.

A simple way to think about the difference between fixed- and variable-rate loans is that fixed-rate loans generally cost a little more, but your minimum payment will never change. Variable-rate loans can be cheaper initially, but your minimum payment will likely change over time.

What Is a Fixed-Rate Loan?
When you borrow with a fixed-rate loan, you lock in your terms when your sign your loan agreement, and even if interest rates go up, your annual percentage rate (APR) will remain the same. For example, if you take out new loan at 4.5 percent APR, then that’s the rate at which you will pay interest for the life of your loan.

One reason borrowers — especially those with long-term loans — prefer fixed-rate loans is that they provide a kind of “interest rate insurance.” They may cost a little more, but that premium protects you against cost hikes down the road.

In general, fixed rates are preferable under the following circumstances:

  • You have a longer loan term and you don’t want to be affected by changing rates.
  • You don’t have room in your budget for an increase in your minimum payment.
  • You believe interest rates will increase in the future and you want to lock in a rate now.

What Is a Variable-Rate Loan?
A variable-rate loan may start out lower than a fixed-rate loan, but it will fluctuate over the life of the loan as its underlying reference rate changes. This means your minimum payment will change as rates change.

Some borrowers prefer variable rates because they don’t want to pay a premium for the “interest rate insurance.” Essentially, they are making a bet that rates won’t rise significantly during their loan terms, which is why variable rates are often the better choice for shorter-term loans.

For student loan refinancing, the underlying reference rate is typically one-month LIBOR. LIBOR, which stands for “London Interbank Offered Rate,” is the rate of interest at which banks lend money to each other. Other types of loans might use the prime rate, or lowest rate of interest at which money is borrowed commercially, as a reference rate. As a borrower considering a variable-rate loan, it’s good to know what your reference rate is so you have a better understanding of how your own rates might move as interest rates change.

One final thing about variable rates to keep mind: There is no limit to how much the reference rate can rise or fall in any one year, but variable-rate loans typically have a maximum APR depending on the state in which you live.

In general, variable-rate loans are preferable under the following circumstances:

  • You have a shorter loan term, which limits the chances for rates to change.
  • You can handle an increased minimum payment.
  • You believe interest rates will decrease or stay flat in the near future.

Catherine New is a member of the DailyWorth Connect program. Read more about the program here.


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