Which Is Better: A Fixed or Variable Rate Loan?

6

When it comes to borrowing money in larger amounts for either a car, mortgage or student loans there are times you have two options on how the bank will calculate the interest over the life of the loan. This can be impacted by different factors, such as the prime rate, government regulations or economic conditions in your area. Below we talk about the two options and which is better: a fixed or variable rate loan.

Fixed interest: This means that at whatever point in time you originate the loan, it will stay at that rate for the interest of the loan. Even though other economic indicators will cause the prime rate to go up and down, your particular rate of interest will stay the same over the life of the loan (The prime rate the lowest possible rate of a loan, set by the federal government. Banks and mortgage companies base their profit margins from a given loan on this rate.)

Variable interest: Also called adjustable rate, this means that over the course of the loan your loan can go up or down according to prevailing changes in the prime rate of your given country. This loan is more popular outside the U.S. where the down payment for a mortgage, for instance, can be as high as 50%. The U.S. only started allowing these types of mortgages in 1982 and the practice has since spread to other financial markets that govern both student and vehicle loans.

Which one is better?

Although the definition is easy enough to understand, which one a person should choose depends on some different variables. The first variable is how much of the purchase you can truly afford according to the down payment and available credit the bank is willing to lend. Typically variable interest will be offered when the person borrowing the money is a larger credit risk. The second variable is how savvy you are as a consumer with knowing the prevailing interest rates. If you are reading the economic news everyday and think that the winds of commerce will change and lower the prime rate, then you might want to try a variable interest rate. If you fear there will be too much volatility (how frequently the rate goes up and down) to make it worth your while, then you might consider another option. The last variable to consider is the life of the loan. As mentioned earlier, variable interest loans are more popular outside the U.S. The life of the loan will determine how often the rate will go up or down.

In many cases, it ends up a decision of how comfortable a person is with the risk of the rate going up and those added expenses being passed on to you, the consumer.

A fixed rate loan may or may not be popular depending on the prevailing economic conditions. Part of the reason the U.S. allowed variable interest loan in 1982 was that double-digit inflation was hampering business in the consumer loan market. Nobody wanted to borrow when a mortgage was at historically high rates. Conversely, the recent crash in the mortgage sector, interest rates have plummeted to a level not seen since the 1960โ€™s. People, if they can get the proper deal are happy to sign a fixed interest loan or mortgage, betting on the fact that interest rates will go up over the next thirty years.

Finally, there may be government programs that influence your decision. Certain government offer special incentives to banks and mortgage companies to sign first time home buyers. Special subsidized mortgage or student loan programs also impact these decisions. Doing a healthy amount of research in your area to see if you qualify for these programs could save quite a bit of money.

In the end, which rate you choose depends on the research you do, and your bankโ€™s willingness to accept your current credit rating. Make sure to practice due diligence when seeking any form of long term credit!

Photo credit: fabonthemoon

6 COMMENTS

  1. My risk averse personality won’t allow me to consider ARMs, but looking back it would have worked out for when we had a mortgage. I think with interest rates as low as they are now, you’d need a pretty compelling reason to go after an adjustable rate.

  2. It depends on what the load is for and the specific terms of the loan.

    For the rental properties that I buy I always try to get the longest fixed rate loan as possible. This creates a known fixed cost that allows me to plan over time.

    For my primary residence I opted for a variable rate loan at prime minus 0.85%. This meant I started off paying 2.15% interest on my mortgage. At the time, a fixed rate mortgage was around 4.85% which meant that prime rate would have to go up to 5.7% before the interest rate I was paying was equal to the fixed rate that was being offered at the time. I felt that it was a good risk to take the prime minus 0.85% and so far so good… fingers crossed inflation doesn’t rear it’s ugly head and send interest rates through the roof!

    Wrapping things up, it all depends on what you’re borrowing the money for, how long you plan to borrow the money for and what your opinion on where interest rates are heading over the life of your loan.

    Thanks for the great post.

  3. My mother in law has an ARM on her house and it drives her nuts. Way to much risk in my opinion with variable rates. Give me a fixed flat rate fee any day!

LEAVE A REPLY