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As you research loan options, you will run into two different types: a variable-rate loan and a fixed-rate loan. There are several considerations you need to take into account when looking at fixed-rate versus variable-rate loans.
While you may think fixed-rate loans are the automatic winner, this is not always the case. In certain situations, you might take out a variable-rate loan. It can give you more affordable payments and help you maximize your savings.
But in which cases does it make sense to go with a fixed rate? And when should you consider a variable rate? Here’s what you need to keep in mind when comparing your loan options.
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Which is Better: Fixed-Rate vs. Variable-Rate Loan?
The data shows that borrowers are likely to pay less interest overall with a variable rate loan versus a fixed rate loan. Keep in mind that historical trends are not always a sign of future performance.
Another critical factor is the amortization period of the loan, which can have a significant impact on your payments. The longer the amortization period, the more you will pay in interest over the life of the loan.
The current interest rate environment should also play a role in your considerations. Over the past 48 years, interest rates on a 30-year fixed-rate mortgage have gone as high as 18.63 percent in 1981 to a low of 3.31 percent in 2012.
There are several forces at play when it comes to interest rates. The Federal Reserve sets the fed funds rate, which affects short-term and variable interest rates. Another factor is investor demand for U.S. Treasury notes and bonds, which affects fixed-rate loans. Banks also play a role since they determine what rate to charge on loans depending on business needs.
The resources below will help you understand each type of loan and how it applies in different situations. Having the right information should help you choose between a variable and a fixed-rate loan when considering your options.
What are Fixed-Rate Loans?
A fixed-rate loan has an interest rate that doesn’t change during the lifetime of the loan. This means that as long as you have the loan, you will have the same interest rate, even if market rates go up. As a result, you will have equal regular payments for the entire life of the loan.
Many of the loans you’ve had over the years were likely fixed-rate loans. The term “fixed-rate” can apply to many kinds of loans. For example, it could be a personal loan, a mortgage, a car loan, a student loan, and so on.
Since it is a fixed loan rate, it only makes sense to lock it down if you’d come out ahead. For example, if interest rates are on the rise, getting a fixed-rate loan will get you a lower rate for the life of the loan.
However, if rates are going down or if there is legislation on the horizon that could cause a rate drop, you will do your wallet a disservice by locking in a rate. This will mean you’ll be paying more for your loan when everyone else is getting a better deal.
While you may refinance your loan and get a better interest rate down the road, there are fees associated. You need to do a cost/benefit analysis to determine if refinancing makes sense.
Keep in mind that the kind of loan and duration will also dictate which type of rate makes sense.
For example, auto loans usually last for 60 to 72 months, while mortgages often span 15 to 30 years. What may be the right loan for a mortgage might not be the right loan for a car purchase.
What are Variable-Rate Loans?
A variable-rate loan has a rate that changes based on market fluctuations. The interest charged is on the outstanding loan balance. This means your payments will vary depending on the current loan interest rate.
Variable-rate loans usually have a lower starting interest rate than fixed-rate loans.They are also known as floating rate loans. There are different variable-rate loans, so make sure you do your research on which type you’re considering.
These types of loans tend to follow a specific banking index. It follows the change in rate banks charge one another to borrow money. This rate can change monthly, affecting both your payment for that month and the total expected interest owed over the life of the loan.
Neutral third parties publish interest rate indexes. There are several different types, so check your loan paperwork to find out which one is followed by your particular variable loan.
However, some variable-rate loans come with a cap. This means that you will never be charged above a set interest rate regardless of how the market interest rate changes.
Having a rate cap can be vital since it prevents your loan payments from getting out of hand in case there’s a steep rise in market rates.
Fixed Rate vs. Variable Rate Mortgages
When considering which type of rate to choose for your mortgage, look at the current interest rate environment. If rates are low compared to the last ten years, it makes sense to lock in a fixed-rate mortgage to secure affordable payments.
If rates have been rising and are near an all-time high, going with a variable rate loan may be favorable. You can refinance your mortgage after a few years to get a better rate.
Getting a variable rate mortgage can also make it more affordable to buy a house in the short term. It may result in lower monthly payments, helping lower your expenses in the first few years of home ownership.
This can also be a great option if you’re looking to stay in your house only for a few years and sell it. It’s important to figure out how long you plan to have a mortgage and when you think you will sell the house.
The most common type of variable rate mortgage is known as an ARM – short for adjustable rate mortgage. The most popular of these kinds of loans is a 5/1 ARM where you get an introductory rate for five years.
After that, the interest rate can change every year. Other types of ARMs you may encounter include 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.
Introductory ARM rates tend to be lower than what you can get with a fixed-rate loan. But once the rate adjusts, this can all change. The difference of 0.25 percent in an interest rate can make a big difference to the tune of tens of thousands of dollars on a 30-year mortgage.
Variable vs. Fixed-Rate Student Loans
What kind of rate you have on your student loans depends, in part, on the type of loan. All federal student loans have fixed interest rates. In contrast, private student loans can have either a fixed or variable rate.
If you’re thinking about taking out student loans, make sure you max out your federal options first. That’s because you can qualify for income-based repayment plans and loan forgiveness programs with federal loans. Private loans don’t give you that option.
When you take out private student loans or refinance federal loans, you can select either a variable or a fixed-rate option. Just like with mortgages, a variable-rate loan can save you money up front. But eventually, you must face an interest rate hike.
Before you sign your name on the dotted line, review all paperwork related to your loan. Once you agree to the loan terms, you will be responsible for paying back every cent, regardless of your financial situation.
Student loans are a growing problem among college students. According to the most recent statistics, 69 percent of students took out loans and graduated with an average debt of $29,800, including both private and federal loans.
Student loans are one of the hardest debts to shake off. Even if you were to declare bankruptcy, getting your student loans discharged is not automatic. You will have to go through several hoops to clear the debt.
Going with a federal loan gives you options for handling a high debt amount. You can ask for an income-repayment plan that will peg your monthly payment to your current income for a defined period. You also have the option to go for loan forbearance if you find work in the public sector.
How to Choose
Choosing a fixed versus variable-rate loan depends on your personal situation and the current economic climate. There is no absolute right or wrong answer. Your situation will dictate which type of loan works best.
For those who enjoy knowing how much their monthly payments will be, getting a fixed-rate loan makes sense. This choice also makes sense if you plan to pay off the loan over a longer time frame such as 10, 20 or even 30 years.
Locking in a fixed rate will eliminate the chance of payments going up because of a rate increase. This type can work well for bigger loans such as mortgages, especially if you plan to stay in the property for the foreseeable future.
On the other hand, getting a variable-rate loan will maximize your initial savings. It may come with a lower payment, which can help you afford the loan with more wiggle room.
However, keep in mind that the interest rate will rise at some point and you will need to prepare for the higher payments.
If you plan to pay off a loan early by making extra payments, a variable-rate loan will save you money. Also, if you buy a home and plan to sell it in the next few years, getting a variable-rate mortgage such as an ARM could make sense.
The only way to change the rate on a fixed-rate loan is to refinance. Variable-rate loans have more wiggle room so you can take advantage of rate drops. On the flip side, your payments can increase if the prevailing market interest rates trend upward.
Whether you go with a variable-rate or fixed-rate loan depends on your situation. Some factors to consider are the loan term, the loan amount and repayment plans. The longer the loan period, the greater the impact an interest rate change will have on your payments.
For example, with a mortgage, an ARM may make sense if you plan to move in a few years. For student loans, maxing out federal loans, which are fixed-rate, gives you more options in case of financial hardship.
Evaluate the pros and cons of each loan type carefully and read the fine print before agreeing to take on the debt.
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