July 9, 2021
Taking out a loan often goes hand-in-hand with a big life event — buying a house or car, attending school. Exciting as these pursuits may be, clearly understanding how interest rates affect a loan is key to maintaining your financial health.
What is a Variable Rate?
A variable rate is an interest rate on a loan that changes based on fluctuating market conditions throughout the course of the loan term.
How Does a Variable Rate Work?
To understand how variable rates work, you'll first need to understand a few things about benchmark rates. When you apply for a variable rate loan, lenders first refer to one of two benchmark rates: the London Interbank Offered Rate (LIBOR) or the prime rate.
The prime rate is the interest rate banks charge customers with the highest credit scores, and it's based on the federal funds rate (the rate banks charge each other for overnight lending), which is set by the Federal Reserve Board, while the LIBOR currently serves as a base cost for banks to use when borrowing from each other.
After lenders consult these benchmarks, they'll add a margin to calculate your rate. The margin remains the same throughout the length of the loan, even though the index rate will change with the market over time. The higher your credit score, the lower the margin will likely be.
Examples of Variable Rate Loans
Some types of loans are available with either a variable rate or a fixed rate, so in the following examples, you'll see some overlap.
What is a Fixed Rate?
A fixed interest rate on a loan stays the same throughout the life of a loan, which means monthly payments will also remain the same amount over the loan term.
How Does a Fixed Rate Work?
But how is that fixed rate determined? When a borrower applies for a fixed rate loan, lenders look to current market rates to set the rate, which again, won't change during the life of a particular borrower's loan.
However, since lenders base fixed rates on market conditions, as well as other loan features, the rate amount that's issued may change from borrower to borrower, depending on market status at the time of application.
Some lenders also offer a range of fixed rates based on borrowers' credit ratings. In this case, borrowers with higher credit scores often qualify for lower rates.
And while fixed interest rates create a more predictable payment plan, they typically tend to be higher than variable rates at the moment of loan approval.
Examples of Fixed Rate Loans
Common types of fixed rate loans include:
Variable Rate vs. Fixed Rate: Which Should I Choose?
Factoring in your financial situation and personal preferences will help you decide whether a variable rate or fixed rate is right for you.
A variable rate might be the best fit for you if:
- Short-term financing is your goal. If you plan on taking 10 years or less to pay off your loan, you'll likely pay less in total interest throughout your loan term.
- You have an immediate need for a lower interest rate.
- You have enough flexibility to plan for potential interest rate and monthly payment increases.
You might choose a fixed rate if:
- Certainty is a priority. You feel more comfortable knowing what your exact monthly loan payment will be — and that it won't change over the life of your loan.
- You would rather not have to budget for potential rate hikes and increased monthly payments.
- You anticipate taking approximately 10 or more years to pay off your loan and don't want to risk the chance of interest rate changes during that period of time.
Consider the Big Picture
Ready to select your rate? Just remember that weighing the advantages and drawbacks of variable and fixed rates in regard to your financial flexibility, comfort zone, and loan-payoff timeframe can help you make an informed decision.