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Fixed vs Variable-Rate Loans – Understanding Rate Types
Before taking out a loan, check what type of rate it carries and how it could impact your payment.
When you apply for a loan, you tend to encounter two different rate types: fixed and variable. Understanding how these rates work is an essential step in choosing the right loan type for you.
Let’s look at the ins and outs of fixed-rate and variable-rate loans so you’re better prepared when shopping for your next loan.
Key Takeaways
Fixed-rate loan rates stay the same during the entire term of the loan and only change if you refinance the loan.
Variable-rate loan rates may fluctuate over time based on the market rate.
Fixed-rate loans are sometimes preferred for the fixed payment amounts throughout the term. But variable-rate loans are sometimes preferred because if market rates drop, the rate on the loan may drop too!
What Is a Fixed-Rate Loan?
A fixed-rate loan has a rate that stays the same for the duration of the loan’s term. Remember, rates are expressed as Annual Percentage Rate, or APR. The rate you receive when you apply for and accept the money is the rate you pay until the loan is paid off. And your rate stays steady even if the market rate changes.
Some of the most common fixed-rate loans include:
Fixed-rate mortgages
Auto loans
Some student loans
Fixed-rate personal loans
What Is a Variable-Rate Loan?
Variable-rate loans have rates that may change throughout your repayment term. These rates are impacted by the market rate, also known as the federal funds rate. The federal funds rate is set by the Federal Reserve and is the rate banks borrow money at.
The most common types of variable-rate loans include:1
Adjustable-rate mortgages
Some student loans
Variable-rate personal loans
Credit cards are another financial product where you’re likely to encounter variable rates. When you make a purchase with a credit card, you’re borrowing against your credit limit. The interest charged on a balance carried over from month to month is often based on a variable rate.
How Do Variable-Rate Loans Work?
As mentioned, variable-rate loans are commonly tied to the federal funds rate. When this rate increases, rates on variable-rate loans often increase as well. And when the Fed lowers rates, the rates on variable-rate loans often drop.
This lets borrowers take advantage of potential savings if rates drop after they take out their loan. But it also exposes them to the risk of a rate increase if the Fed raises rates. Additionally, borrowers may see fluctuations in their payments over time, which may make it harder to manage their bills.
The starting rate on variable-rate loans is known as the initial rate. To entice borrowers, the initial rate is usually set lower than rates on fixed-rate loans and remains constant for a period of time, often ranging between six months and 10 years, depending on the product.2 At the end of the initial rate period, the lender has the right to adjust the rate.3
Certain variable-rate loans, such as adjustable-rate mortgages, have caps established by the underwriter based on the borrower’s credit profile.
Most variable-rate loan caps are based on the borrower’s credit profile.4 Caps limit how much the loan’s rates are able to change and are disclosed in your loan agreement, as required by the Truth In Lending Act.5
There are a few types of caps, including:6
Initial. This determines the maximum amount that your rate could change after your initial rate expires.
Periodic. This outlines the amount that your rate could change during adjustment periods throughout the year.
Lifetime. This limits the maximum amount that your rate could increase over the life of your loan.
With variable-rate loans, you may see your rate change throughout the year, but the caps help reduce the impact those rate changes have on your finances.
Variable vs Fixed-Rate Loans – Which Is Better?
There’s no one-size-fits-all approach here. Both loan types may work well, depending on your situation.
Loan Type | Pros | Cons |
|---|---|---|
Fixed-Rate | Predictable payments May be able to lock in a lower rate before market conditions change | Rates tend to be higher than initial or promotional rates on variable-rate loans If market rates drop, you’re stuck with a higher rate unless you refinance |
Variable-Rate | Lower initial rate than fixed-rate loan Rates may drop, potentially saving you money | Rates may increase, increasing your payment amount and total loan cost. Less predictable payments |
Which Rate Type Is Right for Me?
Both types of loans may help you get the financing you need. Before you submit your application, consider the following factors.7
Overall Costs: Consider how each loan type may impact your financial situation before you apply. Review the term lengths, fee structure, and watch for any penalties. In some instances, a variable-rate loan may offer enough savings up front that it makes the most sense. For other borrowers, the predictability of a fixed-rate loan may offer peace of mind.
Your Credit Score: Before you begin researching your loan options, review your credit score to get an idea of what rates you may be offered. The higher your credit score, the more likely you are to qualify for a lower rate on a fixed-rate loan.
Market Conditions: While it’s impossible to predict future market conditions with certainty, take a moment before signing on the dotted line to research the recent trends in market rates. In a low-rate environment, locking in a low rate on a fixed-rate loan could be a smart move. If rates are trending down, going with a variable-rate loan could end up working in your favor.
Length of Loan: If you’re looking at loans with a fairly short payoff term, such as a year, choosing a variable-rate loan may be the better option, since there may only be a few adjustment periods. Longer-term loans may benefit from a fixed rate since the predictable payments are easier to work into your budget .
As always, it’s important to consult with a financial advisor about your situation to ensure you’re making the best decision for your financial future.
Final Thoughts
Both fixed-rate and variable-rate loans help you access funds you need to cover certain expenses. While fixed-rate loans give you more predictable payments for the life of the loan, you may be able to get a lower initial rate on a variable-rate loan.
As you explore your options, consider how each loan type could impact your finances and do your research up front to make an informed decision.