Interest Rates: Fixed vs. Variable

When taking out a loan or opening a credit line, one of the most important aspects to understand is the type of interest rate to which you're agreeing.

Interest rates can come in two forms: fixed or variable, and the choice between the two can have a significant impact on your financial strategy. In this article, we'll break down the differences between fixed and variable interest rates, how they are applied, and the advantages and disadvantages of each.

What Are Interest Rates?

An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. It’s what lenders charge borrowers for the privilege of using their money, and it’s applied to various types of loans – including mortgages, car loans, student loans, and credit cards.

Interest rates can either be “fixed” or “variable.”

The type of rate you choose will affect how much you pay over time, and your decision should be based on your financial situation, risk tolerance, and future plans.

What Is a Fixed Interest Rate?

A fixed interest rate remains the same for the entire term of the loan. Whether the loan lasts for 5, 15, or 30 years, the interest rate doesn't change, meaning your payments will stay consistent throughout the life of the loan.

How Fixed Interest Rates Are Applied

Loan Payments

With a fixed-rate loan, your monthly payments are predictable. You’ll know exactly how much you owe every month, which helps with budgeting and financial planning.

Long-Term Stability

The rate you lock in when you sign for the loan will stay in place, regardless of fluctuations in the broader interest rate environment. Even if national interest rates rise, your rate won’t increase.

Advantages of Fixed Interest Rates

Predictability

Since your rate doesn’t change, your payments remain stable over the life of the loan. This makes budgeting easier, especially for long-term loans like mortgages.

Protection from Rising Rates

If market interest rates go up, you’re protected because your fixed rate stays the same.

Disadvantages of Fixed Interest Rates

Higher Initial Rates

Fixed interest rates are often higher at the outset than variable rates because lenders are locking in a long-term rate for you.

Less Flexibility

If market interest rates decrease, you’re stuck with the higher rate unless you refinance, which nearly always involves extra costs.

What Is a Variable Interest Rate?

A “variable interest rate,” sometimes called a “floating rate,” changes over time based on an underlying benchmark interest rate, such as the “prime rate” or “LIBOR” (London Interbank Offered Rate). Your payments will fluctuate based on changes in this benchmark, meaning your loan costs could increase or decrease depending on market conditions.

How Variable Interest Rates Are Applied

Loan Payments

With a variable-rate loan, your payments can change periodically, typically on a monthly or quarterly basis. Lenders will often specify a margin (e.g., “Prime + 2%”) that gets added to the benchmark rate to determine your total interest rate.

Fluctuations Over Time

Variable rates are adjusted periodically based on the movements of the underlying benchmark. For example, if the prime rate rises, your interest rate will also rise, and so will your payments. On the other hand, if interest rates fall, your interest rate will fall as well.

Advantages of Variable Interest Rates

Lower Initial Rates

Variable interest rates are often lower at the start of the loan compared to fixed rates, which can make them appealing for borrowers looking to save money early on.

Potential for Decreased Rates

If the underlying benchmark rate decreases, your interest rate will also go down, resulting in lower payments.

Disadvantages of Variable Interest Rates

Unpredictability

Because your payments are tied to market rates, they can increase unexpectedly, making budgeting difficult. If you’re not expecting this increase, it can really destroy your financial planning.

Higher Long-Term Costs

While variable rates may start low, they can rise significantly over time, increasing the total cost of the loan.

Fixed vs. Variable Interest Rates: When It Comes Time To Choose

Choosing between fixed and variable interest rates depends on several factors, including your financial goals, market conditions, and tolerance for risk.

When to Choose a Fixed Interest Rate

Stability and Predictability

If you prefer the security of knowing exactly how much you’ll pay each month, a fixed rate is the better choice. This is particularly important for long-term loans like mortgages, where market fluctuations could dramatically increase payments over the years.

Rising Interest Rate Environment

If interest rates are expected to rise, locking in a fixed rate can save you money over the life of the loan.

When to Choose a Variable Interest Rate

Short-Term Borrowing

If you’re planning on repaying the loan quickly (for instance, within a few years), a variable interest rate may save you money in the short term, as initial rates are typically lower than fixed rates.

Falling Interest Rate Environment

If rates are trending downward, a variable-rate loan could result in lower payments over time. But it’s important to remember that this comes with the risk of rates rising in the future.

Examples of Fixed and Variable Interest Rates in Action

Fixed Interest Rate Loan Example

Let’s say you take out a 30-year fixed-rate mortgage for $200,000 at a 4% interest rate. Your monthly payment (excluding taxes and insurance) would be about $955. Since this is a fixed-rate loan, your monthly payment will remain the same for the entire 30-year term, regardless of what happens to interest rates in the broader market.

Variable Interest Rate Loan Example

Now imagine you take out a $200,000 mortgage with a variable interest rate. The initial rate might be 3%, which makes your monthly payment approximately $843. However, after two years, the benchmark rate rises by 1%. Your new rate becomes 4%, and your monthly payment increases to $955. Over time, if interest rates continue to rise, your monthly payments will continue to grow, making your loan more expensive in the long run.

Which Type of Loan is Better for You?

When deciding between fixed and variable interest rates, consider the following:

1. Your Financial Stability: If your budget is tight and you need predictable payments, a fixed rate will give you more control over your finances.




2. The Economic Outlook: In a rising interest rate environment, fixed rates are a safer option. If rates are expected to fall, variable rates may offer short-term savings.




3. How Long You Plan to Keep the Loan: For long-term loans, like mortgages, fixed rates provide stability. For short-term loans, variable rates might offer savings.




4. Risk Tolerance: Variable rates are inherently riskier because payments can fluctuate. If you’re comfortable with the potential for higher payments, a variable rate might work for you. If not, a fixed rate offers peace of mind.

Bottom Line: Choose Wisely Between Fixed vs. Variable Rates

Choosing between a fixed and variable interest rate is a significant decision that will impact your financial health for years. Fixed rates provide stability and predictability, making them a great choice for long-term loans and for borrowers who prefer to minimize risk.

Variable rates, on the other hand, offer lower initial costs and the potential for future savings, but they come with the risk of rising payments.

Before making a decision, carefully consider your financial situation, the current interest rate environment, and how long you plan to keep the loan. Understanding the differences between fixed and variable rates will help you make the right choice for your needs.