7 Ways to Compare Fixed Rate Loan vs Variable Rate Loan

by Dori Tery on April 20, 2013

Some prefer Variable Loans Than Fixed Loans…

The interest payments associated with a consumer loan can either be fixed or variable. A fixed interest rate loan is not tied to market interest rates. It maintains a single interest rate for the entire duration of the loan. Regardless of whether market interest rates swing up or down, the interest rate you pay remains fixed. The vast majority of consumer loans have fixed rates.

A variable or adjustable interest rate loan is tied to a market interest rate, such as the prime rate or the six month Treasury Bill rate. The interest rate you pay varies as that market rate changes. The prime rate is the interest rate banks charge to their most creditworthy customers. Most consumer loans are set above the prime rate or the Treasury bill rate. For example, your loan might be set at 4 percent over prime. In this case, if the prime rate is 9 percent at the moment, the rate you pay on your variable rate loan would be 13 percent. If the prime rate drops to 8 percent, your rate would change to 12 percent.

Not all variable rate loans are the same. For example, rates may be adjusted at different, but fixed, intervals. Some loans adjust every month, others every year. The less frequently the loan adjusts, the less you have to worry about rate changes. You should also know the volatility of the interest rate to which the loan is pegged. In general, short term market rates tend to change more than long term market rates. Therefore, variable rate loans tied to the six month Treasury Bill Rate expose you to more risk of rate changes than do loans tied to, say, the 20-year Treasury bond rate.

Of course, variable rate loans usually have rate caps that prevent interest rate from varying too much. The periodic cap limits the maximum the interest rate can jump during one adjustment. The lifetime cap limits the amount that the interest rate can jump over the life of the loan The larger the fluctuations allowed by the caps, the greater risk. The bottom line on a variable interest rate loan is that if interest rates drop, you win, and if interest rates rise, you lose.

Fixed Rate Loan Better Than Variable Rate Loan?

So, which is better, a fixed rate loan or a variable rate loan? Neither one necessarily. The choice between a variable and fixed rate loan is another example of risk and return go hand in hand. With a variable rate loan, the borrower bears the risk that interest rates will go up and the payments will increase accordingly. With a risk that interest rates will go up and the payments will increase accordingly. With a fixed rate loan, the lender bears the risk that interest rate will go up and because the interest rate of the loan is fixed – that they will lose interest income. Because the lender bears more risk. Fixed rate loans generally cost more than variable rate loans.

An alternative to a fixed or variable rate loan is a convertible loan. A convertible loan is a variable rate loan that can be converted into a fixed rate at the borrower’s option at specified dates in the future. Although convertible loans are much less common than variable and fixed rate loans, they do offer the advantage of the lower cost of a variable rate loan along with the ability to look into the savings of a fixed rate loan. Read here for Mortgage Lenders of America Ratings and Reviews

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