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Loans aren’t financial contracts that one should take lightly. In the U.S., the total student debt has reached $1.71 trillion, with 44.7 million Americans saddled with student loans.
However, as a potential homeowner, or a graduate student looking to compare student loan refinance rates, sometimes the intricacies of the loan terms can escape you. Things like choosing a fixed rate vs variable rate might not be on your mind.
That’s a shame because have a basic understanding of the differences between variable and fixed interest rates can truly help you meet your financial goals, and even pay less money in the long run.
If you can’t tell the difference between the two rates, no worries. You’ve come to the right place. Keep on reading to learn all about the dichotomy between fixed rate vs variable rate in general, as well as take a deep dive into case studies of mortgages and student loans.
Fixed Rate vs Variable Rate 101: The Differences and Definitions
Let’s start with the basics, and identify the difference between a fixed and a variable-rate loan.
The Fixed Rate Loan
In the simplest of terms, the fixed-rate loan is a loan with a constant interest rate that stays the same throughout the entire life of the loan.
As the loan holder, you’ll know exactly how much interest you’ll be paying every month, and the loan totals, all before getting the loan funds in the bank. Basically, since the interest rate never changes, your monthly payments will also stay the same. You’ll be getting a clear picture before you even need to start paying back the loan.
The Advantages and Disadvantages of Fixed Rate Loans
If you’re looking for ways to minimize risks and increase your rates of certainty, then picking a fixed-rate loan is the way to go. The main perk of getting a fixed-rate loan is that what you see is what you get.
You’ll know exactly how much you’ll be paying every month, so there’s no risk of your installments getting unaffordable as time goes on.
On the other hand, this certainty comes with its own drawbacks. You’ll have to contend with the fact that fixed-rate loans usually come with higher-rates when compared to a similar initial interest rate on a variable-rate loan.
Thus, you’ll be paying more upfront for the loan, and there will be no escaping that. You have to give up the chance of having low rate loans that come with variable rates.
The Variable Rate Loan
On the other side of the financial spectrum, we have the variable-rate loan. This is a loan that has a fluctuating interest rate, even if the loan’s terms state that the rate will be fixed for a specific period of time.
For instance, you might take out an adjustable-rate or variable-rate mortgage. The loan rate might be fixed for the first three years (or longer), but once this time period expires, you’ll be facing a changing interest rate depending on the market.
Moreover, the amount of time decided for that initial interest rate to stay locked tends to vary depending on the kind of loan. You might be aware of loans with rates that are fixed for a minuscule period of time. Or, a loan that has a restricted rate that only adjusts once per year, or bi-annually, or even monthly. It all depends on the lender and the type of loan you’re looking for.
The Basis of the Variable Rate Adjustments
The adjustments of the variable rates don’t come from the void. Traditionally speaking, you’ll find that variable-rate loans are tied to a specific financial index, like LIBOR, or the Prime Rate.
The loan adjustor will usually take the index plus a specific percentage, like the Prime Rate plus 4%. The relationship between the variable rate and the index is directly proportionate. Therefore, if the index goes up, the interest rate will also go up, and vice versa.
Considering that the interest rate is ever-changing with a variable-rate loan, you should expect your monthly payments to change as well. This will result in differing monthly payments, and you’ll find yourself either paying higher or lower monthly payment amounts in comparison to your initial monthly payments.
The Advantages and Disadvantages of Variable Rate Loans
You can simply switch the pros and cons of fixed-rate loans, and you get the advantages and disadvantages of variable-rate loans.
For example, it’s a great asset to your finances to start with a lower rate. This rule is even more effective if you’re aware that you’re going to financial struggle initially, but you’re expecting your income to rise as time goes on.
Of course, the downside here is the big question mark you’re leaving to fate, the big risk of your rate going up instead of down. If you’re unlucky, and the rate went up, that makes your borrowing more costly and expensive in the long run.
The worst-case scenario would be the rate going uncontrollably up, which can transform your initially-small monthly payments into crippling monthly nightmares that you can’t pay consistently, putting you at risk of defaulting on your loan.
Making the Right Choice: Fixed Interest Rate or Variable Rate Loan?
The short answer is that it truly depends on your situation. The overarching studies have found that the borrower is likely to pay less interest overall with a variable-rate loan than a fixed-rate loan, especially when the data sets are held over a long period of time.
However, people can’t always trust historical data to be concrete indications of financial future performance. As a borrower, you’ll want to calculate the amortization period of your loan. The longer the amortization period of your loan, the greater the impact the change in interest will have on your monthly payments.
Based on these studies, we can assume that in the case of mortgages, going for adjustable-rate mortgages (ARM) are better for the borrower, specifically in an environment with a decreasing interest rate.
Unfortunately, if the borrower is stuck in an environment with an increasing interest rate, the mortgage payments will sharply rise.
Besides, an ARM might be a good fit for borrowers that plan to sell the homes after a couple of years, or borrowers that are pre-planning for mortgage refinancing in the short term. Essentially, the longer you plan to hold on to the mortgage, the riskier an ARM will be.
After all, the initial interest rates on an ARM might be low and rather tempting to hold onto, but once the adjustment of the rate starts, you’ll be facing higher payments than comparable fixed-rate loans.
For your knowledge, this is what happened during the subprime mortgage crisis, with many borrowers falling into the trap of having unmanageable mortgage interest rates once their initial teaser rate expired.
Student Loans: Fixed or Variable Rates Are Better?
You’ll notice that all federal student loans have fixed interest rates. A general rule of thumb is maxing out your federal student loan options before taking a look at private student loans. The great financial benefit of federal student loans is the ability to qualify for income-driven repayment plans, as well as loan forgiveness programs.
Of course, private loans don’t come with these security nets.
If you’re doing your research on private student loans, or even refinancing your existing student loans through a private lender, you’ll have the option of going for a fixed or a variable-rate loan.
Here are the general conditions that can help you make the best decision for your financial situation.
Pick the Fixed-Rate Loan If:
You might prefer having stable payments (and who can blame you?), in this case, you’ll want to pick a fixed-rate loan. Also if you feel like you’ll need more time to repay your loan, so 10 years or longer, you should pick a fixed-rate loan, and definitely shy away from variable-rate loans.
Remember what we said about the studies conducted on the amortization of loans? The longer your loan term rate, the higher the probability that your interest rates will go up, so play it safe and choose a fixed-rate loan.
Pick the Variable-Rate Loan If:
If you have strong cause to believe that interest rates will remain steady, with the market trends and indicators showing that interest rates will remain stable, then you might want to take the gamble and pick a variable-rate loan.
Furthermore, if you’re choosing a short loan term, so a loan that’s five years or shorter, then you’ll be in a safer position when it comes to market fluctuations. Therefore, going the variable-rate loan route might be a smart way to save money.
Or, you might actually have a go-big-or-go-home plan of aggressively paying off your debt. In this case, you might as well take advantage of the lower initial rate, which can help you get rid of your debt faster.
Exploring Your Loan Interest Rates
We know that diving into the world of interest rates, and the whole comparisons between fixed rate vs variable rate can be a bit overwhelming, especially for those who’re planning to borrow for the first time.
We hope our guide was able to shed some light on the differences between fixed-rate and variable-rate loans, and when it would be better for your financial situation to pick one over the other.
Just remember to take it slow, and compare rates from different lenders for the best rates you can find.