Interest Rates

When you take out a loan, you have an option to choose between a variable or fixed interest rate. Having an understanding of the difference between the two and the risks associated with each one can help you make an informed decision and avoid potential consequences down the line. While fixed interest rates remain constant throughout the life of the loan, variable interest rates may fluctuate depending on a variety of factors, such as economic conditions.

Interest Rates

Interest rates are essentially the price that a borrower has to pay to the lender to obtain money for a certain purpose, such as for a mortgage to purchase a home, to obtain a student loan, or to purchase an automobile. The interest payments are owed by the debtor in addition to the principal balance of a loan. For instance, if you're buying a house, you may need to take out a mortgage for a portion of the purchase price of the home. Let's say, you're buying a house for $150,000 and you've saved 50,000 in cash, you may want to borrow money for the remaining $100,000. The $100,000 becomes the principal balance, and the interest charges are in addition to the principal balance. Your monthly payments will cover part of the loan as well as the interest rate costs. The money that you'll eventually pay will be more than the actual amount of the loan.

Fixed Rate

A fixed interest rate is set at the beginning of the loan and doesn't change, keeping the payments the same throughout the loan term. A fixed interest rate is determined by the going market rates at the time the loan is approved. Therefore, if market conditions change overtime, a fixed rate loan is locked in and will remain the same, no matter what happens in the market. This is beneficial for people who are primarily interested in making sure that they're able to accurately budget their short-term and long-term finances. With a fixed rate, you don't have to worry about whether market conditions will cause your monthly loan payments to rise. Your payments are predictable over the course of the loan.

Variable Rate

When you apply for a loan, variable interest rates will more than likely be lower than fixed rates. This is beneficial when you sign the loan agreement, as your payments may be lower than the fixed rate options for a similar term. The interest rates may adjust during the loan period, as economic conditions change. With a variable rate, you run the risk of your monthly payments substantially increasing, if the interest rates go up. On the other hand, if the rates go down, your payments, of course, will decrease, which can help you save money. Depending on the duration of the loan, a variable interest rate can be the more attractive option for shorter loan terms. However, there is no guarantee that the lower rates will continue for the entire loan period.

Your choice between a fixed and a variable interest rate loan will ultimately depend on your individual circumstances and long-term goals. In many cases, variable interest rates are often lower than fixed rates in the beginning, but there's a potential risk that these variable rates will increase, causing your monthly payments go up. When loan payments rise due to an increase in interest rates, some people may experience problems making payments, if they're not financially prepared for this unexpected change. If you're fully aware of the pros and cons of each type of loan, and you've compared this information to what you're realistically able to afford over a period of time, you're in the best position to make the decision that's right for you.