Reading your loan options can feel like learning a foreign language. What is Fixed or Variable Loan? And what on earth is an interest rate index? Whether you are taking out a home loan or financing your next vehicle, you are sure to encounter the same conditions.
A fixed rate loan is for people who can get a low interest rate and have never gambled one before. But that doesn’t mean that floating rate loans don’t have their advantages. Let’s talk about the differences between these two types of loans and what they can mean for your bottom line financial result.
What is a Fixed Rate Loan Compared to an Adjustable Rate Loan?
The main difference between a fixed rate loan and a floating rate loan is that your loan payment stays the same at a fixed rate and can fluctuate at a floating rate.
Let’s look at an example.
Imagine receiving a mortgage at a rate of 2.75% over a 30 year period. Your bank calculates your monthly payment and stays the same for the life of your loan. For example, let’s say you are offered a 2.5% floating rate loan. That sounds appealing, but if interest rates go up in the real estate market, your interest rate could go up. Within five years, you might be paying closer to 3.25% interest and owe a few hundred dollars more each month.
|Fixed Rate Loans||Variable Rate Loans|
|Prices||Stay the same over the course of the loan||Fluctuate according to market conditions|
|Loan amounts||Vary by type of loan||Vary by type of loan|
|conditions||Stay the same for up to 30 years depending on the type of loan||Change based on market conditions and may include a balloon payment at a specified time|
[ Read: Best Auto Loans ]
Understanding Fixed Income Loans
What is a fixed loan? As mentioned above, a fixed rate loan is a loan where the consumer (that’s you) pegs an interest rate when they complete their loan. This interest rate remains stable throughout the life of the loan, unless you refinance.
Fixed rate loans are popular when it comes to financing that ranges from auto loans to mortgages to personal loans. They are ideal for those who are risk averse or for anyone lucky enough to find finance when interest rates are at historic lows. Many companies also opt for a fixed rate business loan because reliable loan payments make it easy to forecast future expenses and create profit targets.
One drawback, however, is that a person tied to a fixed rate loan may pay a higher than average interest rate when market rates fall. For example, a consumer who received a 48-month auto loan in the first quarter of 2020 would likely have offered an interest rate of 5.29 percent (based on average commercial bank rates). A few months later, the average interest rate on the same loan had dropped to 5.13%. If that consumer were tied to a fixed rate loan, they would be paying more per month than someone who got a loan the following quarter.
Understanding adjustable rate loans
What is a variable loan? One of the main advantages of an adjustable rate loan is that the initial interest rate is often lower than what you offer on a fixed rate loan. This can be attractive to consumers on a tight budget. However, floating rate loans are not stagnating.
Most floating rate loans fluctuate based on what is known as the base rate. The base rate can also be referred to as the base rate. This interest rate is set by individual banks, but is influenced by the interest rate on federal funds (this is the interest rate that banks charge each other for short-term loans). The Fed, short for The Federal Reserve System, analyzes current economic conditions eight times during the year and adjusts the federal rate accordingly. When the key rate rises or falls, the key rate usually rises too, which has a direct impact on floating rate loans.
You may be offered adjustable rate loans for a variety of financing options. Usually, however, these loans apply to long-term loans. Student loans and home loans are most likely to offer adjustable interest rates. Home loans can initially have a fixed interest rate for a set period of time (often five years). From this point on, the interest rate can change. After the housing bubble burst in 2008, only 10-15% of buyers opted for an adjustable rate mortgage between 2008 and 2014, although historically up to 30% of buyers opted for an adjustable rate mortgage.
What are interest rate caps?
If you choose a floating rate loan, your lender will set the interest rate caps as part of the loan terms. You can think of these caps as caps on the interest rate. An interest rate cap can affect how high your interest rate can go, or how many points it can go up at one time.
There are three main types of interest rate caps. The initial adjustment cap affects how much your interest can increase at the end of the Fixed Rate Period. Often times this upper limit means that your interest rate cannot increase by more than a few percentage points at the end of the fixed term.
After this initial period, you may also have a subsequent adjustment cap. This indicates how many points can simultaneously increase your interest for each future period.
Finally, there is a lifelong interest rate cap. This is the rule of how much your interest rate can increase from the original interest rate on the entire loan. For example, your lender may agree to never increase your interest rate more than 5% above your original interest rate. If you had paid 2.75% when you started your loan, your interest rate would never go above 7.75%.
[ Read: Best Personal Loan Rates for 2021]
Should I get a fixed rate loan or a variable loan?
Whether you should get a fixed rate or an adjustable rate loan depends on a variety of factors. If you are on the fence, these insights should be kept in mind as you navigate the loan application process.
|Loan type||Fixed Rate Loans||Variable rate loans|
|personally||Good for consumers with good credit who have access to low rates||Good for short term loans when the interest rate can hardly fluctuate drastically|
|student||Best when the floating rates are high and a precise budget is a priority||Best of all when fixed rates are currently high and likely to fall|
|mortgage||Ideal for buyers who want to stay in the house for the long term||Only works for buyers who can process a higher payment than currently|
|business||Ideal for small businesses that need a reliable budget to make ends meet||Ideal for thriving businesses that believe interest rates are falling and can be approved for refinance when interest rates rise|
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