When shopping for loan, we want to find the cheapest loan with the best terms for us. Maybe the most important price we pay on our debt is the interest rate. Meaning that interest rate represents the price you pay on the amount you borrow. As such, it is a factor that determines the cost of your loan i.e. the cost of debt. Note that it is one of the factors, not the single most important factor, there are other factors that should be taken into account to determine the full cost of the loan. Make sure you understand which loan is the best loan for you. Because of the effect an interest has on the price of your loan, you should know the two basic types of interest rates you could choose from, the fixed and variable interest rate loan. Accordingly, you should understand the difference between fixed interest rates loans and variable interest rates loans. A wrong decision regarding the type of interest rate you are going to pay, can have harsh impact on your financial situation.
What is variable interest rate loan?
A variable interest rate is an interest rate that can be subject to changes during the life time of the loan. Meaning that, there could be positive or negative difference in the interest rate at the time of signing the loan agreement and the interest rate during or at the end of the loan term. The next logical thing for you would be to understand the reason responsible for changes in the interest rate. Namely, when a loan has a variable interest rate, it is periodically adjusted in accordance to the current market interest rates. Depending on the type of loan, some of the common interest rate benchmarks are: LIBOR, COFI or MTA. In addition, the level of economic activity and inflation rate, among other factors, are influencing the direction of the movement of market interest rates (benchmark rates).
Thus, when taking a variable rate loan, due to the possibility for the interest rate to change, your monthly payments are also subject to change. Meaning that, an increase in the benchmark interest rate, would result in an increase in your monthly payment and vice versa.
What is fixed interest rate loan?
Contrary to the variable interest rate loan, having fixed interest rate loans means that the interest rate will not vary in accordance to the movements in the market interest rates. As the name implies, this type of loan has the same interest rate throughout the entire loan repayment period. This means, that regardless of the movements in the market interest rates, your monthly payment will not be subject to changes (there are certain exceptions though). Thus, any uncertainty about the direction of movement of interest rates in the future is removed.
As with everything else, prior to making any decision, you should consider the advantages and disadvantages of each type of interest rate. That is, you cannot choose fixed or variable interest rates until you are fully aware about the benefits and consequences.
Advantages of variable interest rate loan
- Lower monthly payment – variable interest rate loan can offer you the possibility to enjoy a lower monthly payment in the short-run.
- Borrow more – with variable interest rate loan you could be able to borrow more money even if you don’t have the best credit score.
- Increased flexibility – you are allowed to make extra payments if you want.
Disadvantages of variable interest rate loan
- Possible budgeting problems – due to the changing nature of the interest rate and the fact that interest influences the size of the monthly payment, having variable interest rate loan, makes it difficult to know the exact monthly payment every month or six months ahead.
- Rises in interest rates – could have minor or substantial negative impact on your finances. This in a sense that it could increase your monthly payments, which could lead to worsen financial health.
Advantages of fixed interest rate loan
- Easier budgeting – since the monthly payment is fixed you could plan ahead your monthly finances, and the danger of fluctuations in your monthly obligation is eliminated.
- Upward changes in interest rates – any rise in market interest will not have negative impact on people with fixed interest rate loan.
Disadvantages of fixed interest rate loan
- Not riding on the decreases in interest rates – the downside is that, any decrease in the market interest rates will not be reflected in your monthly payment, because you have opted for fixed rate.
- No extra payment – having fixed interest rate loan could be an obstacle for you to make an extra payments for your loan. This is because of the terms enacted on the fixed interest rate loans by the lenders.
- Early repayment charges – could exist for a fixed interest rate loan
It could be said that fixed interest rate loan is good for people who have near perfect credit score. This is so because, a good standing credit score can qualify you for a lower interest rate. Thus, you could lock in a low interest rate on your loan. Another thing to consider is the fact that fixed interest rates are higher than variable interest rates.
The decision about fixed versus variable interest rate loan is especially important if you plan to apply for long-term loan (mortgage loan for example). The longer the life of the loan, the bigger the uncertainty about the movement in the market interest rates, the level of your income, financial health, etc. Thus, time i.e. the life span of the loan should also be taken into consideration when deciding whether to fix your interest rate or not.
By know you should understand the relation between your monthly payment and the interest rate. Namely, the size of the monthly payment is affected by the interest rate. As it was mentioned before, the interest rate has an important influence on the size of your monthly payment because it is consisted (on most loans) from a portion of the principal amount plus an interest payment on the outstanding balance.
It is good to take a loan bearing a fixed interest in times when the market interest rates are relatively low, or when there is a significant fluctuations in the market interest rates. On the other hand, a variable interest rate loan could be beneficial if there are realistic expectations that the market interest rates will gradually and constantly decrease in the future.
Although taking into consideration the type of interest rate you are going to pay is highly important, you should not base your decision solely on the type of interest rate. Meaning that you should base your decision on the full cost you will have for the specific loan. It is also important to understand the difference between APR and interest rate. In addition, amortization period of the loan is also important. This is so because, the length of the loan repayment period is highly important as well. An important issue that should be considered here is the repayment period. Longer amortization period bears higher risk, in terms of the possibility for changes in the size of the interest rate to occur.
Noteworthy mentioning is that the interest rates in the past couple of years are considered to be all time low. Accordingly, fixing the interest rate on your loan could be beneficial in terms of saving made on interest payments i.e. lower cost of the loan.