If you have ever looked into taking out a loan, whether it was a mortgage, personal loan, or student loan, you more than likely had to decide between a fixed interest rate or variable interest rate. Fixed rate loans and variable loans can both be useful according to the borrower’s unique situation as well as their risk aversion level. Before deciding on the type of interest rate you want, it is important to know the difference between the two, and what situation calls for both.
A fixed interest rate, as the name implies, will not change throughout the duration of the life of the loan. If you want security and assurance in knowing that your payment will never increase, you should go for a fixed rate on the loan. With a fixed rate, once you sign the loan agreement, your interest rate and payment will never change. Fixed rate loans usually have higher rates than variable loans because of this “premium” the borrower pays to lock themselves in at a certain interest rate.
Variable rate loans, unlike fixed rate loans, have an interest rate that can fluctuate over the life of the loan. As a result, your monthly minimum payments have the ability to increase or decrease depending on the movement of interest rates. Because of this uncertainty and inherent risk associated with a variable rate loan, your original interest rate will start out lower than with a traditional fixed rate loan.
In the United States, the starting point for loan interest rates is the LIBOR (London Interbank Offered Rate). This is the rate at which banks lend money to each other in London. It is widely used as the basis for interest rates in other countries, including the U.S. It is from the LIBOR rate where banks and financial institutions add their premium according to an individual borrower’s creditworthiness.
There are several factors you should consider when deciding between a fixed rate and a variable rate. For shorter term loans, where there is less of an opportunity for rates to rise, you should strongly consider a variable rate. On the flip side, for longer term loans, if you do not want to be affected by a future increase in interest rates, you should go with a fixed rate loan. In addition, if you can handle an increase in your monthly payment and/or you plan on paying off your loan early, you should consider a variable rate. If you are against an increase in your monthly payment, a fixed rate is better for you. Lastly, if you like to speculate and you believe that interest rates will remain the same or decrease in the near future, you should choose a variable rate loan. On the contrary, if you believe they will rise and you wish to lock yourself in at rate now, a fixed rate loan is best for you.
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