Understanding Variable Interest Rates

PercentageSignWhen choosing a loan, the interest rate is one of the most important factors you will consider. There are two primary types of interest rates: variable and fixed. While fixed interest rates remain constant throughout the life of the loan, variable interest rates change over time.

About Variable Interest Rates

If you agree to a loan with a variable rate, the bank will offer you an initial interest rate that is lower than the fixed rate available for the same loan amount. This rate will remain constant for a predetermined amount of time known as the “introductory period.” After the introductory period is over, the rate will change according to fluctuations in the lending market. Most variable rate loans include a cap, which is a limit on the maximum interest rate the bank can charge.

Advantages

During the introductory period, the interest rate on a variable rate loan is usually lower than the rate on the best available fixed rate loan of the same size. For this reason, the payment on a variable rate loan will be lower at the beginning of the term. Because the loan payment is lower, a variable rate loan is also easier to obtain than a fixed rate loan.

As long as the market rates stay down, a variable rate loan may continue to offer a lower payment than a fixed rate loan of similar size. In addition, variable rate loans usually have more flexible options when it comes to the length of the loan.

Disadvantages

Variable rate loans are unpredictable. Because monthly payments fluctuate, borrowers may encounter budgeting difficulties or have trouble planning for their financial future. If prevailing market rates increase, the rate on the loan will increase as well. If rates increase dramatically, the payment may become difficult or impossible to afford. Furthermore, loans with variable rate interest rates include more options and complex terminology, which makes them harder to understand than fixed rate loans.

Choosing a Variable Interest Rate

If you anticipate that market rates will be declining for the foreseeable future, a loan with a variable interest rate is a good choice. Variable interest rates are also wise for borrowers seeking loans with relatively short terms.

On the other hand, you should not choose a variable interest rate if you are doing so in order to secure a loan you can’t actually afford. If any increase in your introductory interest rate would make the payment unbearable, don’t agree to a variable rate loan.

 

Member FDIC. Member DIF.