When shopping around for a loan, you may encounter “fixed rate” and “variable rate” loans. These terms pertain to the loan’s APR and apply to various loans across the financial landscape. For instance, a lender may offer mortgages with both fixed rates (fixed rate mortgages) and variable rates (adjustable-rate mortgages).
Both fixed rate and variable rate loans can make sense for your financial needs in different situations, so let’s explore the differences between them to learn which one may be the right choice.
Fixed Rate Loans
With a fixed rate loan, the interest rate remains the same throughout the loan term. A fixed rate is not affected by any changes in market interest rates, which means that borrowers have an assurance that their monthly loan payments will never change.
Types of Fixed Rate Loans
Lenders offer a few different types of fixed rate loans. Here are a few key examples:
- Auto loans: Most auto loans have a fixed interest rate that makes their monthly payments a predictable expense in budgets or financial plans.
- Home equity loans: A home equity loan allows you to leverage home ownership for a lump sum loan. These are typically fixed interest loans but should not be confused with home equity lines of credit (HELOCs) which could have variable interest rates.
- Personal loans: Most personal loans are unsecured loans that come with fixed interest rates.
The Pros of Fixed Rate Loans
Fixed rate loans have some benefits that make them a popular choice, such as:
- Fixed monthly payments: Since interest never changes, borrowers know their monthly payments will never increase.
- Easy to calculate borrowing costs: A fixed interest allows you to calculate how much interest you will pay in total over the life of the loan. This predictability may help you compare loans and determine the loan’s overall affordability.
The Cons of Fixed Rate Loans
Like all financial products, fixed rate loans have some aspects that may make them a poor choice for some borrowers. Some of these are:
- Rates never decrease: Fixed interest rates are great when market rates rise, but they’re less beneficial when market rates decline. Being locked into a fixed rate means your loan’s interest rate never decreases.
- Higher interest rates: Historically, fixed rates have usually been higher than variable rates. Borrowers will usually pay more interest overall on a fixed rate loan when compared to a variable loan.
Variable Rate Loans
A variable interest rate loan is one in which market changes influence the interest rates levied by the lender. The interest rate may increase or decrease throughout the loan term and may result in correspondingly higher or lower monthly payments.
The loan's interest typically ties back to a reference rate or benchmark index, such as the prime rate. These benchmarks give lenders a base interest rate to which they may add a margin. Lenders will usually add the base interest rate and the margin together when calculating the interest rate to offer consumers.
Types of Variable Rate Loans
You may know that credit cards and lines of credit have variable interest rates, but variable rate loans can also include products like:
- Adjustable-rate mortgage (ARM): This type of variable interest mortgage gives you the benefit of an initial rate that remains fixed for a certain period of time before a variable rate is implemented. However, keep in mind that other loans may not work the same way.
- Variable rate personal loans: Some lenders also offer personal loans with a variable rate, though these may be less common.
The Pros of Variable Rate Loans
Variable rate loans have some upsides that make them attractive to some borrowers. They may offer benefits such as:
- Monthly payments may decrease: The primary benefit of variable rates is that your monthly payments decrease when the market interest rates decrease. This shift can help reduce your overall expenditure on interest and may help you save more.
- Variable rates may be lower than fixed rates: Since the borrower incurs more risk with a variable rate, lenders usually offer comparatively lower rates.
- Initial rate period: Some lenders may offer a low introductory rate (on certain loans such as ARMs) that may last a few months or years, depending on the loan. So, you would pay a lower interest rate during this promotional period.
The Cons of Variable Rate Loans
Anyone considering applying for a variable rate loan should also consider its downsides. Variable rate loans may have drawbacks such as:
- Rising monthly payments: Monthly loan payments may increase when market interest rates rise. Even minor increases can affect your monthly payments therefore your overall finances and budget.
- Risk of defaulting: A sudden hike in interest rates may increase your monthly payment to the point where you can't pay it back and risk defaulting.
- Monthly budgeting could be harder: Not knowing if your monthly payments will increase might mean that it's more challenging to plan your long-term finances.
How do I choose between a fixed rate and a variable rate loan?
There are some important factors to think of when choosing between fixed and variable rate loans. You'll need to consider your own financial situation to decide properly.
Purpose of the Loan
Your choice between a variable and fixed rate loan may depend on how you intend to use the loan. If you’re buying a house, most lenders will offer you a choice between fixed and variable rate loans. But if you need a personal loan for a household emergency or are looking for a car loan, you may have a harder time finding a lender willing to give you a variable rate loan.
Nobody can predict whether interest rates will rise or fall, but you may be able to use the current rates and market situation as a guide. If interest rates have been steadily rising, a fixed rate loan may be the better alternative. Similarly, if rates have declined, you may benefit from a variable rate.
Choose the best loan for you
When you’re considering the benefits of fixed rate loans vs. variable rate loans, the key deciding factors are your own needs and market research. You may want to note interest trends, the possibility of prepayment fees, the purpose of the loan and the availability of certain loans before making a decision.
No matter what you choose, remember to compare rates, fees, and terms as much as you can before submitting a formal application.
Disclaimer: Citi offers personal loans to both existing Citi customers and new Citi customers that meet specific eligibility criteria, including an established credit and income history along with additional factors determined by Citi. If you think you could benefit from a Citi Personal Loan, apply online today.
Disclosure: This article is for educational purposes. It is not intended to provide legal, investment, or financial advice and is not a substitute for professional advice. It does not indicate the availability of any Citi product or service. For advice about your specific circumstances, you should consult a qualified professional.