Fixed vs. variable interest rates: What’s the difference?

Two main types of interest rates are fixed and variable rates. Both represent the cost of a loan but work a bit differently. Fixed interest rates remain constant throughout the loan term, whereas variable rates can change throughout the life of your loan. This article will explain how fixed and variable interest rates differ and then explore several factors borrowers can use to determine which is best for them.

Here’s what we’re going to cover:

• What is a fixed interest rate?
• Types of loans with fixed interest rates
• What is a variable interest rate?
• Types of loans with variable interest rates
• What’s the difference between fixed and variable interest rates?
• Is a fixed or variable interest rate better?
• Oportun: Affordable lending options designed with you in mind

What is a fixed interest rate?

A fixed interest rate on a loan remains the same throughout the loan term. It doesn’t change, even if external interest rates change after the borrower gets the loan. For example, let’s say you get a fixed-rate loan of $5,000 at 5% interest. Your interest rate will stay at 5% for the duration of the term, even if prevailing interest rates change. This means your repayment installments are likely to be the same over the course of the loan, unless other factors are also influencing your repayment schedule.

Types of loans with fixed rates

Here are some of the most common fixed-rate loans (though they can also be variable rate):

Personal loans

Personal loans are lump sums you can borrow and repay in fixed installments of principal and interest. They can be helpful for many purposes, such as:

• Consolidating and refinancing debt
• Large purchases
• Medical bills
• Wedding expenses
• Moving costs
• Home or car repairs

Auto loans

In many cases, people finance a vehicle purchase with a loan. A fixed interest rate on auto loans makes it easier to budget for a vehicle, alongside car insurance, maintenance, and other costs.

Fixed-rate mortgage

Mortgages are some of the largest and most common fixed-rate loans. Homebuyers can take out fixed-rate mortgages to create a predictable payment schedule over the long (often 15 or 30 years) term.

Ideally, a homebuyer gets a fixed-rate mortgage when prevailing interest rates are low. This helps them minimize their monthly payment and save on interest in case rates rise in the future. Homebuyers may also refinance from variable-rate to fixed-rate mortgages or from higher to lower-rate mortgages when prevailing rates are low.

What is a variable interest rate?

Variable interest rates change alongside an interest rate called the prime rate or with an underlying index or benchmark interest rate. These external rates may seem like they have nothing to do between you and your lender, except that you’ve agreed to tie your interest rate to them. The external rates do not remain the same throughout the life of the loan.

Many variable-rate loans move with the prime rate, which fluctuates when the US Federal Reserve changes the federal funds rate. The federal funds rate is how much interest banks can charge other banks for borrowing money.

With a variable rate, your payment sizes are likely to change.

Types of loans with variable interest rates

Here are some types of variable-rate loans (which can also be fixed-rate loans):

Credit cards

Credit cards let you borrow throughout the month at your leisure. Many cardholders use credit cards for everyday expenses like gas and groceries due to the convenience, plus credit card companies often provide a rewards program for spending on the card.

At the end of a billing cycle, you receive a monthly statement detailing your charges, total balance, and minimum payment. You must make the minimum payment to avoid late fees and damage to your credit score. Anything left unpaid becomes a balance carried to the next period, which you’ll have to pay interest on and adds to the balance. Credit cards tend to have high, variable interest rates.

Home equity lines of credit

Home equity lines of credit, or HELOCs, let homeowners tap into their home equity to borrow funds. They can use these funds for nearly anything. Common uses include home renovations and repairs, emergency expenses, and consolidation or refinancing of other debts.

Personal lines of credit

Personal lines of credit work like credit cards but can have lower interest rates and higher borrowing limits. You can borrow from your line of credit by writing checks against it, making online transfers, or spending with an associate debit card. At the same time, personal lines of credit may be more tedious than credit cards for frequent transactions. They also don’t offer rewards or a grace period in many cases. These features can make them better suited for larger, infrequent purchases, like furniture.

What’s the difference between fixed and variable interest rates?

The key difference between fixed and variable interest rates is predictability. Fixed rates offer more predictability since they don’t change throughout the life of the loan. You can build your monthly payment into your overall budget.

Variable rates change with their underlying rate, adding uncertainty to your financial planning and budgeting. This can work in your favor if interest rates drop, but is more expensive if they rise.

For example, imagine you get a 30-year, $200,000 mortgage at 5% interest. Your monthly payment is $1,074 for the next 360 months. That’s simple to work into your budget. After one year, prevailing mortgage rates rise to 6%. Your interest rate is still 5%, so your monthly payment is unchanged. However, if your mortgage had a variable rate, your rate would rise above 5% and your payment sizes would increase.

Is a fixed or variable interest rate better?

Neither interest rate is better in all cases. The best kind of rate for you depends on several factors:

• Term length: A fixed-rate loan may work better for longer time horizons. Meanwhile, variable-rate loans tend to suit short-term circumstances to reduce the chance that the rate increases beyond affordability.
• Interest rate trends: If rates are expected to rise, a fixed-rate loan could help you lock in a lower rate. If rates are expected to fall, a variable-rate loan could help you save, especially if the loan is not long-term.
• Risk tolerance: Fixed-rate loans can work better if you prefer predictability over potential cost savings. A variable rate could suit you well if you are comfortable with more interest rate risk.
• Economic conditions: Economic factors like inflation or a recession can impact interest rates. Furthermore, they can affect your ability to make your monthly payment. Fixed-rate loans might be better options if economic conditions are predicted to worsen, whereas variable-rate loans may be more feasible if economic projections are strong.

Oportun: Affordable lending options designed with you in mind

Now that you understand the difference between fixed and variable interest rates, you can learn about how Oportun may be able to help you if you’re looking for affordable credit options. Visit our homepage  to learn about:

• Personal loans
• Credit cards
• Secured personal loans
• And more!

Sources

Investopedia. Fixed vs. Variable Rate Loans: Which is Better?

ValuePenguin. Fixed vs. Variable Interest Rates: What’s the Difference?