When you borrow money, you may have a choice between a fixed-rate loan or a variable-rate loan. Read on to find out how to choose which one is right for you.
Image source: Getty Images.
When you borrow money, the interest rate you pay is one of the most important considerations. Interest is the cost of borrowing, and the higher the rate, the more expensive your loan will be.
As you shop around to compare interest rates, you’ll likely notice you have two choices: You could opt for a fixed-rate loan, or you could opt for a variable-rate loan. You’ll likely face this choice with personal loans, private student loans, mortgage and home equity loans, and even some car loans.
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 need to think about.
Understanding fixed vs. variable-rate loans
When deciding between a fixed versus a variable-rate loan, it’s imperative to understand how each of these loans works and what the difference between them is.
If you opt for a fixed-rate loan, the interest rate stays the same for the entire life of the loan. You’ll know exactly how much interest you’ll pay each month, and in total, before you receive the loan funds and before you begin paying the loan back. Since the interest rate never changes, your monthly payments also never change.
With a variable-rate loan, on the other hand, your interest rate is not fixed for the life of the loan. It may be fixed for a set period of time. For example, if you took out a variable rate or adjustable rate mortgage, the loan rate might be fixed for the first two years, or five years, or even longer. After that period of time when the fixed rate expires, your loan’s interest rate can adjust.
The specific amount of time your initial interest rate is locked in will vary depending upon the kind of loan. In some cases, your rate is only fixed for a very short time. The frequency at which your rate can adjust is also determined by the lender and type of loan. Your rate may be restricted to adjusting just once per year, or it may adjust monthly or bi-annually.
With a variable-rate loan, the rate is usually linked to a financial index. Your loan may be linked to the Prime Rate or to the LIBOR index. It’s usually equal to that index plus a certain percentage, such as Prime Rate plus 3%. If the financial index your loan is linked to goes up, the interest rate could go up. If it goes down, the interest rate could go down.
Because your interest rate is able to change with a variable-rate loan, your monthly payments could change too. This means you could end up paying a higher -- or lower -- monthly payment than you started with.
Pros and cons of fixed-rate loans
Opting for a fixed-rate loan is generally a better choice if you want to minimize risk. You’ll know going in exactly how much you’ll be paying each month and you won’t take a chance on your payments rising and becoming unaffordable over time.
Unfortunately, this certainty can come at a cost. Fixed-rate loans generally have higher rates than the initial starting interest rate on a variable- or adjustable-rate loan. This means you’ll be paying more up front for the loan that you take on than you would if you opted for a variable-rate loan.
Pros and cons of variable-rate loans
Variable-rate loans have the opposite pros and cons compared with fixed-rate loans.
With a variable-rate loan, you generally start with a lower rate -- which is a big pro. That’s especially true if you’re going to struggle initially to make loan payments but you expect your income will rise.
The downside is that you take a big risk. There’s always the chance that the rate could go down, which is another pro. However, there’s also a chance the rate could go up. This could make borrowing much more expensive in the long run, and it could even put you at risk of defaulting on your loan depending upon just how high the rate goes.
Is a fixed or variable-rate loan right for you?
Ultimately only you can decide whether a fixed or a variable-rate loan is the right type of loan for your situation.
If you’re planning on paying off the loan over a very long time -- such as when you take out a mortgage and plan to stay in the home for 30 years -- it makes sense to take out a fixed-rate loan. After all, chances are good that interest rates will rise over a long period of time, so you’re taking a big chance that you’ll end up with a more expensive loan.
If you cannot afford for your payments to go up at all, then a fixed-rate loan is also the better option. You don’t want to gamble on not being able to make your payments when rates inevitably go up. It’s worth paying a little extra up front to avoid this precarious situation as defaulting on a loan could destroy your credit and affect your long-term financial stability in serious ways.
On the other hand, if you’re only going to have the loan for a short time, a variable loan may make sense -- especially if you plan to pay off or refinance the loan before the rate could adjust. However, even this is risky because there’s not always a guarantee you’ll be able to pay off or refinance as expected. If you took a mortgage with a variable rate, for example, property values could fall and could leave you unable to sell your home to repay the loan, even if you were planning on doing so.
If you’re considering a variable-rate loan, make sure you understand exactly when and how payments will adjust -- and what the maximum monthly payment will be. If the maximum monthly payment is too high for you to afford to pay, you should strongly consider passing on the variable-rate loan due to the high risk of something going wrong that leaves you in default.
Make a smart choice on variable vs. fixed-rate loans
It’s important when comparing loans that you consider whether the rate is variable or fixed so you can compare apples to apples. You should also think seriously about the pros and cons of each option, rather than just assuming the lower variable-rate loan is always the best deal. By weighing your options carefully and considering your overall financial situation, you can make the right choice about which loan type is best for you.
The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.