Last editedJul 20214 min read
From personal loans for a new car to renewing the mortgage on your house, applying for a loan can seem like a daunting and complicated process – especially when it comes to choosing the type of interest rate attached to your loan. The two most common types of loans you’re likely to come across are variable or fixed rate loans.
This article will help you to understand exactly what they are, the key differences between the two, explain the dangers of taking a variable rate loan and answer the question “is a student loan a variable or fixed rate loan?”, starting with some guidance on which type you should choose.
Should you choose a variable or fixed rate loan?
Having a thorough understanding of what variable or fixed rate loans are will help you to decide which option might be the best and most affordable for you. The key difference between the two types of loan is how the interest rate is determined for each.
With variable interest rate loans, the interest rate that’s applied to the outstanding balance on the loan changes according to the market. Usually, the interest rate that’s applied is linked to an index or benchmark. However, your monthly payments on your loan will change as the interest rate increases and decreases.
By contrast, the interest that’s paid on a fixed rate loan remains stable for the entire term of the loan. This means that no matter what the market is doing, your payments will remain the same for the entire term, even if the market interest rate is increasing.
When weighing up the pros and cons of variable vs. fixed rate loans, it’s important to know what’s going on with interest rates in the wider market. If interest rates have been falling for a while and it’s likely that they’ll increase soon, then choosing a fixed rate loan will mean you pay less over the long term. However, if the opposite is occurring, and interest rates are about to fall, then a variable rate loan might be a better option.
What is the danger of taking a variable rate loan?
Although some studies have shown that most borrowers pay less over the long-term with variable rate than they do with fixed rate loans, they might not always be the best option for everyone. Although the interest rates applied to variable rate loans are benchmarked, they can still move by a percentage or two with sudden changes in the market. This will impact those who’re borrowing significant amounts of money considerably.
If you’re looking at getting a long-term loan, then looking at an amortization schedule of the loan might help you to understand which option might be best. This schedule what percentage of each monthly payment is going towards the interest rather than the principal of the loan. Typically, the amount contributed towards interest drops over time. For long-term borrowers, this might make variable rates a better option.
However, if you prefer the reassurance of having the same loan repayment being taken from your account monthly or are borrowing for the short-term, then a fixed rate might be the option to go for. Taking the type of loan into account is also important. For example, choosing an adjustable-rate mortgage, where interest rates are fixed for five years before being made variable, is a great way to ensure security and potentially take advantage of a decreasing interest rate in the long-term.
Alternatively, for borrowers looking to get a student loan, then the options available for you to save in the long term are slightly different.
Is a student loan a variable or fixed rate loan?
Student loans are available under both variable and fixed rate terms. However, all federal student loans have fixed interest rates, with only private borrowers offering variable rate loans. Choosing the right student loan for you depends on a variety of factors including:
How much money you need to borrow and for how long
Whether you’re planning on paying off your student loan quickly or over the long-term
The current rate of interest on the market
Many lenders recommend that borrowers looking for student loans choose the safer, fixed option. However, if you’re planning on getting a stable job and paying back your loan as soon as you leave college then a variable rate student loan might be a great option for saving you money.
What is the difference between variable and fixed rate student loans?
As with other types of loans, the main difference between variable and fixed rate student loans is how the rate of interest applied to the loan is set. Fixed rate student loans are offered by both federal and private lenders to those who are borrowing for the first time or looking to refinance their existing student loans.
The main benefits of fixed rate student loans are that the monthly payments are the same. This makes them a great option for those who can’t pay off their loan quickly or who are uncertain if they’ll get a stable job once they leave college. It’s also a preferable choice if market interest rates are set to rise.
However, if market interest rates are falling or you’re looking to pay off your student loan quickly after college, then variable rate loans may be a great option for you. Offered by only private lenders and with interest rates based on the London Interbank Offered Rate (Libor), rates often start out lower than those for fixed loans and will change over the term of the loan.
If you’re considering a variable student loan, it’s important to understand if the lender will adjust the rate monthly or quarterly and if they apply a cap to the interest rate. This will help you to determine how often the monthly payment will change and if you’ll always be able to afford it.
For those looking to refinance their student loans, then it’s important to work out the numbers before making your final decision. Variable loans are a great option for aggressive repayments, but there may be very little difference in interest rate if you opt for a fixed loan.
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