Variable Rate Vs. Fixed Rate
An interest rate is the cost incurred for borrowing funds from a lender, such as a bank or a business. Examples include interest charged on mortgage loans, business loans, credit cards and personal loans.
There are two basic types of interest rates, fixed and variable. Each has pros and cons. Understanding how your situation fits into the interest rate scenario is fundamental to selecting the right type of loan for you.
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Fixed-Rate Basics
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A fixed interest rate is one that is set upon loan initiation, and remains at the agreed-upon rate for the duration of the loan. Fixed rates are generally used with mortgage, auto and other personal loans, and are based on the financial index rate on the date of loan initiation. An advantage of a fixed-rate loan is that the payments are always the same.
Variable-Rate Basics
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Variable rates are tied to a financial index, such as the prime rate or the London Interbank Offered Rate. Therefore, increases in that index result in subsequent increases in variable-rate loans. The impact on the consumer is a change in payments.
Variable interest rates are most commonly used on credit cards and mortgages. Variable-rate loans can be beneficial when interest rates are low, but they tend to be fairly unpredictable.
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Causes of Rate Changes
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The Federal Reserve can make a decision to raise or lower the discount rate, which is the rate charged banks to borrow funds. The bank passes increased fees from rate changes on to the consumer, in the form of higher interest rates on credit cards and mortgages.
In general, variable-rate agreements are more susceptible to fluctuations. Changes to the interest rate for a fixed-rate credit card are possible, but not common. Changes to fixed rates on loans do not occur unless something like refinancing or delinquency changes the status of the account.
Weighing options
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According to Investopedia, studies have shown that over time, the loan borrower will generally pay less interest with a variable-rate loan than on a fixed rate loan. However, this can vary according to the length of the loan and according to the economical situation of both the borrower and the nation as a whole. If timed correctly, you can save money in the long run.
Risk
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Often, the appeal of a fixed-rate loan is that it is considered low-risk borrowing. A variable rate, on the other hand, carries a much more significant degree of risk, and the borrowers must be able to absorb any increases in payments. The greater the amount of the loan, the more drastic the potential changes in the monthly payment.
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References
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