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If you’re shopping for a loan, you may be able to choose between a variable interest rate and a fixed interest rate. What’s the difference? And, which one is better?A variable rate loan often comes with a lower interest rate than a fixed rate loan but, as its name implies, that interest rate can vary, or change, during the life of the loan.Which type of loan is better for your situation may depend on the amount and length of the loan, as well as the overall economy, and where interest rates may be headed in the near future.Read on to learn how a variable rate loan works, how it compares with fixed-rate loans, and some key things to consider when applying for variable loans.
Variable Rate Defined
A variable interest rate is an interest rate on a loan that can fluctuate over time because it’s based on an underlying benchmark interest rate that changes periodically. That benchmark is often the prime rate, which is the lowest rate banks charge corporate customers.What is a variable rate loan? As mentioned above, variable loans have interest rates that can change over time. The variable interest rate is often the prime rate plus a few percentage points (known as the “margin”), which is the profit for the lender.What is a danger of taking a variable rate loan? There’s a risk that your loan may become more expensive over time. The interest rate on a variable rate personal loan changes depending on the current financial markets. When the economy grows, the interest rate on the loan may rise and when it shrinks, the rate can fall. That leads to a lower or higher payment on your loan.A variable rate typically starts out cheaper than a fixed interest rate, but it can potentially increase and be more costly a few years into your loan term. Depending on the lender, you may be able to make extra repayments or pay off the entire loan early without facing penalties.
How Variable Rate Loans Work
What is a variable rate loan? As stated earlier, a variable rate loan is a financial lending product with an interest rate that can fluctuate over time. The way these loans work is the borrower receives funding and repays the loan over time, including principal and a variable rate of interest.Whether your variable rate goes up or down is largely determined by macroeconomic factors, including inflation, consumer activity, and monetary policy decisions by the Federal Reserve that may influence a bank’s prime rate. Again, what is a danger of taking a variable rate loan? It’s the risk that your loan may become more expensive if your interest rate goes up.
Variable Rate Loan Types
Below are some of the different types of variable rate loans you can get:
Personal Loans
There are many reasons to get a personal loan, such as consolidating debt, paying for a home improvement project, or starting a small business. Personal loan offers often come with fixed rates, but some lenders offer variable rate options.Since rates often start out low with a variable rate personal loan, these types of personal loans can be a good option for a personal loan you plan to pay off relatively quickly.
Student Loans
Federal student loans made since July 2006 come with fixed rates, while many private student loan providers give you a choice between fixed rates and variable rates on student loans.You may want to keep in mind that because your student loan likely has a term of 10 years or longer, you may pay more in interest if rates rise than you would with a fixed interest loan.
Mortgage Loans
A variable rate mortgage, often referred to as an adjustable rate loan or mortgage, is a home loan where the interest rate is adjusted periodically to reflect changes in the benchmark interest rate.Mortgage lenders may offer variable rates on the home loan for the entire term of the loan or offer a mortgage that combines both fixed and variable interest rates. For example, a lender may offer an initial three- or five-year period where the interest rate is fixed, after which it follows the benchmark rate and market fluctuations.Recommended: Personal Loans vs Mortgages
Credit Cards
Many credit card annual percentage rates aren’t fixed, so you may have no other option than to get a variable rate card. The rates on variable interest rate credit cards can change without advance notice to the cardholder. When getting a credit card, you may avoid paying interest if you have a grace period and pay your statement balance in full each billing cycle. Some credit cards may feature a 0% introductory APR on purchases and balance transfers. This gives cardholders a 0% fixed interest rate on purchases during the length of the promotional period.
Pros and Cons of Variable Interest Rates
Deciding between a fixed- or a variable-rate loan can be tricky, as there are pros and cons to consider for both options. To help you make the choice, here are a few key factors that you may want to consider:
Pros of Variable Interest Rates
A major pro of a variable rate loan is that you generally start with a lower rate. This can be helpful if you will struggle to make loan payments initially but expect your income will rise and paying a higher monthly repayment will become easier.Another plus is that there is a chance that the benchmark rate will go down, which means your interest rate on your loan will also go down.Variable rate loans also often offer options and flexibility. You may have the option of paying more than the minimum required amount when the interest rate is low, shorten your loan term, or switch to another lender without facing any penalty fees.
Cons of Variable Interest Rates
On the other hand, if the benchmark rate rises, you’ll pay more. If you have a large loan like a mortgage or student loan, even a half-percentage-point increase in interest can cost a significant amount.Indeed, it’s possible for variable interest rates to go up to the point where you may have difficulty paying the loan.Another potential downside of a variable loan is that as interest rates change, so will your monthly payment, which can make this type of loan more difficult to budget for.Here’s a snapshot look of the advantages and disadvantages of a variable rate loan:
Pros
Cons
It typically starts out with a lower interest rate than a fixed rate loan
There’s a chance the interest rates will go up, increasing the cost of the loan
The benchmark rate might fall during the loan term, which would lead to an even lower interest rate
If the interest rate increases significantly, there’s a greater risk you will default on the loan
Variable vs Fixed Rate Loans
There are a number of factors to consider when choosing between a variable or fixed rate loan:
What Is a Fixed Rate Loan?
With a fixed rate loan, the interest charged on the loan will remain fixed for that loan’s entire term, no matter what market interest rates do. Your monthly payments are typically the same each month.When a loan is fixed for its entire term, it remains at the then-prevailing market interest rate, plus or minus a “margin” charged by the lender that is unique to the borrower.
Differences Between Variable and Fixed Rate Loans
Variable rates are often lower than fixed rates, at least when you take out a loan, which can make them more appealing than fixed-rate loans. However, those rates may go up. Generally speaking, if interest rates are relatively low at the moment but are about to increase, then it can be better to lock in your loan at that fixed rate.If you are taking out a larger loan or one with a long repayment period, like a mortgage or student loan, a fixed rate can provide a safer bet because you can calculate from the start what you will pay in interest over the duration of the loan.If you are borrowing a smaller amount, say for a personal loan, and/or have a shorter repayment period, a variable interest loan could be a good idea, since you may pay off the loan before the interest rate rises significantly.If you want a mortgage, but plan on selling your real estate or refinancing the loan after a short period, you might consider variable-rate loans.Recommended: What Are the Pros and Cons of Personal Loans?
Determining if a Variable Rate Loan Is for You
To determine if a variable rate loan is the right choice for your situation, you may want to ask yourself the following questions:
How much money do I want to borrow? The larger the loan, the greater you’ll feel a rise in interest, and the more you’ll pay if rates go up.
How long will it take me to repay the loan? The longer the term, the more you’ll be at the mercy of the ebbs and flows of the benchmark interest rate.
Can I afford the loan if payment amounts go up? If you cannot afford for your payments to go up at all, then a fixed-rate loan is likely the better option. It may be worth paying a little extra up front to avoid the risk of defaulting on the loan.
Are interest rates likely to go up or down in the near future? If benchmark interest rates may fall soon, a variable interest rate loan may be a better bet. If they are likely to rise, you may do better with a fixed rate loan.
Does a Variable or Fixed Rate Loan Work Better for You?
Your personal circumstances may determine whether a variable-rate loan vs. fixed-rate loan is right for you. If you need a long-term personal loan, a fixed interest rate may give you more clarity on how much your loan will cost over time. As mentioned earlier, variable rates are often lower than fixed rates when you take out a loan. A variable rate personal loan may be right for you if there’s no prepayment penalty and you have the ability to pay off your personal loan early.
Discovering Personal Loan Rates With Lantern
To determine which option will work best for your situation and budget, it’s a good idea to shop around and compare interest rates for both variable and fixed rate loans. With Lantern by SoFi, you can get personal loan offers from multiple lenders with just one application.Compare personal loan rates and apply in minutes.
Frequently Asked Questions
Is a personal loan a variable rate loan?
Is it a good idea to get a variable rate loan?
Is it better to have a fixed or variable loan?
Photo credit: iStock/Panuwat Dangsungnoen
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About the Author
Susan Guillory
Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
