Fixed interest vs. variable interest rates: Your guide

If you’re in the market for a mortgage or a loan, you’ve probably discovered that lenders offer loans with either a fixed or variable interest rate. What is the difference between fixed and variable interest rates? While the terms may seem simple at first, fully understanding their implications is crucial when choosing a loan.

Key takeaways:

• A fixed-rate loan locks in your interest rate for the life of the loan, which gives you predictable payments.
• A variable-rate loan fluctuates with a market index, which can result in savings, but also carries the risk of your rate increasing.
• Loan type matters. Whether you need a mortgage or a student loan it could determine whether a fixed or variable rate is best.
• Always consider the fees, loan term, and your personal budget before making a choice.

What is a variable-rate loan?

A variable-rate loan has an interest rate that changes throughout its term.

The interest rate on a variable-rate loan usually is tied to a financial index, such as the secured overnight financing rate (SOFR) or the prime rate. When those index rates increase or decrease, so does your loan’s rate.

There are limits, however. Every variable-rate loan has specific terms that limit the amount by which your rate can change and the frequency of adjustments. These include rate caps, which limit the amount your rate can increase in any one adjustment, as well as how much it can increase over the life of your loan. Rate caps help you decide whether a loan could become too expensive for you, should the worst-case scenario arise.

Lenders also take your creditworthiness into account when offering you a variable-rate loan. The stronger your credit, the more likely you are to get a lower rate.

Variable-rate loans resemble adjustable-rate mortgages, or ARMs, which give you a low introductory interest rate for a limited time before fluctuating over time. Whether a variable-rate loan is the best option for you depends on your specific situation.

Variable rate pros and cons

Here are some pros and cons of variable-rate loans.

What is a fixed-rate loan?

A fixed-rate loan has an interest rate that never changes. This means your monthly payment won’t change, which makes it easier to plan a budget and predict your expenses.

With a fixed-rate loan, your interest rate is set at the time of loan origination. Lenders base your rate on the current market rate. They also consider your credit score and your overall financial profile.

If you have good or excellent credit, you may qualify for a lower interest rate. If your credit score isn’t high enough to get a lower interest rate, you can apply with a co-signer to improve your credit profile.

While Rocket Loans℠ doesn’t currently offer the ability to add a co-signer on personal loans, it might be worth exploring if your credit score is low.

It’s also important to know if the loan you’re being offered has a prepayment penalty. This is a fee that is charged if you pay off your loan early. It’s important to read your loan’s terms carefully, since paying off your loan early potentially saves you a lot of money in interest.

Fixed rate pros and cons

Are variable-rate loans better than fixed-rate loans?

The best loan for you is the one that meets your needs, your budget, and your financial goals. You might prefer a variable-rate loan, especially if you think rates are going to consistently fall in the future, or you may prefer the predictable payments of a fixed-rate loan.

Here are three key factors you should fully understand about the loans you consider before signing on the dotted line:

• Lender fees. Personal loans often include origination fees, sometimes called an up-front or one-time fee. Mortgages include application, origination, and underwriting fees. Understanding these fees is crucial because they significantly impact the overall cost of your loan.
• Term length. Stretching out your loan term will reduce your monthly payment, but you’ll likely pay more in interest over the life of the loan. Conversely, while you’ll typically enjoy a lower interest rate and lower overall interest with a shorter term, your payments may be higher since you are paying off the loan more quickly.
• Personal budget and income. The best loan for you aligns with your budget and income. You want to comfortably afford the payments. This is important for your peace of mind, but also has other potential effects. For instance, if your loan raises your debt-to-income ratio (DTI), it could affect your ability to borrow in the future.

Why loan types matter

The type of loan matters significantly when considering whether to opt for a fixed interest rate or a variable interest rate loan. Some loans are more affordable when the interest rate is fixed, while others are more affordable when the interest rate is variable.

Mortgages

If you’re buying a home, an ARM can save you a lot of money in the early years of your loan. This is because the introductory interest rate is typically lower than that of a fixed-rate loan. So, if you plan to sell your home within that introductory period – typically 3 to 10 years – it could save you money.

However, if you plan to own the home long-term, and rates increase, it could cost you more than expected, as even small rate hikes can result in significantly higher payments.

Student loans

If you have a low credit score, a federal student loan will likely be the best option since your credit score doesn’t affect the rate, which is always fixed. Federal loans are issued by the government and come with specific protections and relief options.

Private student loans, on the other hand, offer both fixed and variable rates. They also consider your creditworthiness, so if your credit score is good, you could score a low rate. You also have the option to refinance a private loan in the future to improve your rate or terms.

If your creditworthiness improves, you can always refinance your federal student loans with a private loan – you use the money from the private loan to pay off the federal loan. However, you may lose certain protections and flexibility.

FAQ

Here are answers to common questions about choosing a fixed-rate vs. variable-rate loan.

Why would someone choose a variable rate?

It’s possible for borrowers who choose variable rates to pay less if interest rates go down. You may also want to take advantage of the lower introductory rate.

Is it better to go with a fixed rate or a variable rate?

It depends on the type of loan and the current market conditions. There is no one-size-fits-all answer for every loan type. The answer can vary depending on whether you’re choosing a credit card, getting a mortgage, or refinancing a loan.

Can I switch from a variable-rate to a fixed-rate mortgage?

Switching from a variable-rate loan to a fixed-rate mortgage requires refinancing your mortgage.

The bottom line: Choosing fixed vs. variable interest rates

Both fixed-rate loans and variable-rate loans have advantages and drawbacks. Variable-rate loans offer flexibility and potential savings in interest costs, especially if you plan to pay them off soon or expect rates to drop in the future. Fixed-rate loans provide predictable payments and peace of mind. The best option for you depends on your financial profile and goals.

Visit Rocket Loans today to explore your options and get prequalified for a personal loan.