It's important to understand the differences between variable interest rates and fixed interest rates if you're considering a loan. Whether you're applying for a new mortgage, refinancing your current mortgage, or applying for a personal loan or credit card, understanding the differences between variable and fixed interest rates can help save you money and meet your financial goals.

Key Takeaways

  • A variable interest rate loan is a loan where the interest charged on the outstanding balance fluctuates based on an underlying benchmark or index that periodically changes.
  • A fixed interest rate loan is a loan where the interest rate on the loan remains the same for the life of the loan.
  • A variable rate loan benefits borrowers in a declining interest rate market because their loan payments will decrease as well.
  • However, when interest rates rise, borrowers who hold a variable rate loan will find the amount due on their loan payments also increases.
  • A popular type of variable rate loan is a 5/1 adjustable-rate mortgage (ARM), which maintains a fixed interest rate for the first five years of the loan and then adjusts the interest rate after the five years are up.

Variable Interest Rate Loans

A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. The interest charged on a variable interest rate loan is linked to an underlying benchmark or index, such as the federal funds rate.

As a result, your payments will vary as well (as long as your payments are blended with principal and interest). You can find variable interest rates in mortgages, credit cards, personal loans, derivatives, and corporate bonds.

Fixed Interest Rate Loans

Fixed interest rate loans are loans in which the interest rate charged on the loan will remain fixed for that loan's entire term, no matter what market interest rates do. This will result in your payments being the same over the entire term. Whether a fixed-rate loan is better for you will depend on the interest rate environment when the loan is taken out and on the duration of the loan.

When a loan is fixed for its entire term, it remains at the then-prevailing market interest rate, plus or minus a spread that is unique to the borrower. Generally speaking, if interest rates are relatively low, but are about to increase, then it will be better to lock in your loan at that fixed rate.

Depending on the terms of your agreement, your interest rate on the new loan will stay the same, even if interest rates climb to higher levels. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan.

Which Is Better: Fixed Interest Rate or Variable Rate Loan?

This discussion is simplistic, but the explanation will not change in a more complicated situation. Studies have found that over time, the borrower is likely to pay less interest overall with a variable rate loan versus a fixed-rate loan. However, historical trends aren't necessarily indicative of future performance. The borrower must also consider the amortization period of a loan. The longer the amortization period of a loan, the greater the impact a change in interest rates will have on your payments.

Therefore, adjustable-rate mortgages (ARM) are beneficial for a borrower in a decreasing interest rate environment, but when interest rates rise, then mortgage payments will rise sharply. The most popular ARM loan product is the 5/1 ARM, in which the rate remains fixed, usually at a rate lower than the typical market rate, for five years. After the five years is up, the rate begins adjusting and will adjust each year. Use a tool like Investopedia's mortgage calculator to estimate how your total mortgage payments can differ depending on which mortgage type you choose.

An ARM might be a good fit for a borrower who plans to sell their home after a few years or one who plans to refinance in the short term. The longer you plan to have the mortgage, the riskier an ARM will be. While initial interest rates on an ARM may be low, once they begin to adjust, the rates will typically be higher than those on a fixed-rate loan. During the subprime mortgage crisis, many borrowers found that their monthly mortgage payments had become unmanageable once their rates started to adjust.