When you’re seeking a new loan, be it a mortgage, student loan, or line of credit, there are two relevant types of interest rates you can expect to encounter: variable vs fixed rate interest. In some cases, you’ll get to choose between which type of interest to select for your loan. So it’s important to understand how they work and which one may be best for you.
Let’s explore what variable vs fixed rate interest means, outline the pros and cons of each, and look at some specific loan scenarios like variable vs fixed home loans and variable vs fixed rate student loans!
Variable vs fixed rate interest: How they work
First things first...what do these terms mean, and how do they work? Let's dig into how variable rate interest works first.
How variable rate interest works
When you have a variable rate on your loan, your interest rate fluctuates over time in response to changes in the market. As a simple example, you could be paying 5% one year, 4% the next year, and 6% the year after that.
A variable interest rate has two components:
- The fixed margin, which is determined based on your creditworthiness and doesn’t change.
- The variable interest rate index, which is the part that does change based on market fluctuations.
The fixed margin is calculated the same way as any loan interest rate. The lender will look at your credit score, history, and (depending on the type of loan) your debt-to-income ratio. The more positive your results are, the lower your fixed margin will be.
So, try to have a good credit score so you can pay less in interest! (Check out our free course on how to build and improve your credit.)
Interest rate indexes
The variable part of the interest rate is determined by an interest rate benchmark or index. Usually, your variable interest rate will be tied to one of these three indexes:
- LIBOR: This stands for London Interbank Offered Rate, and is the most common index for student loans. It can also be used for mortgages, interbank loans, and more. However, LIBOR is being phased out in the next few years.
- Prime rate: Mortgages, small business loans, personal loans, and credit cards are often based on the prime rate. The prime rate is based on the Federal Reserve’s federal funds rate and how large banks respond to it. The Wall Street Journal publishes the consensus prime rate based on a survey of the 30 largest banks. Stay on top of the current prime rate here!
- SOFR: The Secured Overnight Financing Rate is the benchmark replacing LIBOR in 2023.
The lender can choose which benchmark they’ll use for their variable rate loans. But they don’t control when it goes up or down or by how much. Learn more about federal interest rates, along with how they go up and down and how they affect you.
Often, variable rate loans will come with an interest rate cap, which limits how high the interest can rise. This helps limit the risk; you won't suddenly be blindsided with a 50% interest rate one year!
How fixed rate interest works
Well, we got the complicated one out of the way first. So take a deep breath — fixed rate interest is exactly what it sounds like! The interest rate stays the same over the lifetime of the loan, without changing. E.g. you start out paying 5%, you’ll keep paying 5% until you’re done with the loan.
Benchmarks like the prime rate do still impact the interest rate you receive when you apply for a fixed-rate loan, though. Lenders factor in current market interest rates along with your individual creditworthiness when determining a fixed rate to offer you.
The difference is that once you have your rate, you don’t have to worry about any future changes in the benchmarks. You’re set!
Variable vs fixed rates: Pros and cons
Variable and fixed-rate loans both have their benefits and disadvantages. Knowing the pros and cons can help you decide which one is best for you!
Variable rate pros and cons
Let’s start with why you might (or might not) want to choose a variable rate for your loan.
Pro: Historically lower average rates over time
In the past, borrowers with variable rate loans have ended up paying less in interest overall than their counterparts with fixed rate loans, according to Investopedia.
This trend could hold true in the future as well, but it’s important to remember that past performance doesn’t guarantee future results.
Con: Riskier if market interest rises
When you have a variable rate loan, you accept the risk that you’ll pay more if market interest increases. This makes them a lot more of a gamble. The longer you have the loan, the greater the chances that interest will rise.
Before accepting a variable rate loan, make sure to find out if there’s a cap on how high the interest can get, and how often the rate is subject to change (usually monthly or quarterly).
Pro: More flexible repayment or refinance options
Variable rate loans often offer more flexible terms, especially if it’s a mortgage loan. For instance, fixed-rate loans often come with strict terms on breaking your mortgage (which also means it’s harder to refinance it, sell the house and move, or even pay it off early without fees).
Variable rate loans are generally much easier and cheaper to get out of, refinance, or prepay.
Con: Harder to predict your budget
When you have a variable rate loan, you can’t always be sure what your payments will be in upcoming months and years. Depending on how tight your budget is, this can make it harder to plan. Your payment could get higher or lower from month to month or year to year.
Fixed rate pros and cons
You can pretty much flip around all the pros and cons of variable rate interest to understand the perks and drawbacks of fixed rate loans! Let’s go over them quickly.
Pro: More stable and certain
With a fixed rate loan, the rate you start with is the rate you’ll pay for the life of the loan. That means you can expect consistent payments every month, making it a simple task to manage your cash flow and budget. Many people find the lower risk less stressful.
Con: Historically higher average rates
As we already covered, studies show that people with variable rate loans have ended up paying less in overall interest in the past — which also means that people with fixed loans have paid more. Again, that doesn’t mean the same thing will remain true in the future!
Pro: Can be lower if market interest rises
If market interest rises, the people with variable rate loans could potentially face steep increases. When you have a fixed rate loan, you don’t have to worry about fluctuations like that.
During periods of high interest, you may find that your fixed rate loan is lower than a lot of people’s variable ones.
Con: Less flexibility
Fixed-rate loans, especially mortgages, can be difficult and expensive to get out of or change. This is fine if you’re committed to a long-term loan, get a great rate right off the bat, and don’t anticipate needing much flexibility.
But it’s less ideal for people who want something shorter-term and expect they’ll want to move, refinance, etc.
Variable vs fixed rate loan examples
Now, let’s take a closer look at some specific types of loans and which type of interest may be best given the historical data and potential risks.
Variable vs fixed home loan
Mortgages are usually the longest loan you’ll ever sign up for — how should this affect your variable vs fixed home loan interest decision? Do you want a consistent, stable payment or one that might change over time? Do you trust interest rates to stay low in the future?
Many homeowners choose fixed rate mortgages because of their stability and predictability. The most common mortgage term is 30 years, which is a lot of time where the economy can change. Choosing a variable interest rate for a loan this long can be risky.
However, there is one good argument for choosing a variable rate for your mortgage: it can be better if you don’t plan to keep the mortgage for a very long term. If you’re buying a starter home or don’t expect to be in that location for many years, a variable rate mortgage offers greater flexibility (as we discussed in the pros and cons section above).
There are also combination mortgages, like 5/1 Hybrid Adjustable Rate Mortgages (ARMs). In this structure, you have fixed interest for the first 5 years, then variable interest which changes once a year after that.
This can provide an attractive alternative for people planning shorter-term mortgages. In the long term, it comes with the same risks as any variable rate loan.
Determine your unique situation when comparing variable vs fixed home loans.
Variable vs fixed rate student loans
When it comes to variable vs fixed rate student loans, you don’t always have much of a choice. Federal student loans are only available with fixed interest, so you’ll get whatever the current federal rates are in the year you get the loan. You can view current federal student loan interest rates on StudentAid.gov.
Federal student loan rates are generally lower than private loans. It’s best to pursue federal loans first if they're available to you. (That's why about 90% of student loan debt is federal!)
If you need to get a private student loan to finish funding your education, you should have a choice between variable vs fixed rate student loans.
Going with the variable rate could make sense if it’s a decent amount lower and you plan to pay it off quickly after you graduate. A fixed rate could make sense if you’re taking out a lot of loans and expect it to be a decade or more before they’re paid off.
There are also other considerations at play when it comes to selecting student loans, so make sure to read up on the types of student loans and how they work.
Variable vs fixed rate credit cards
Most credit cards automatically come with variable interest rates. You don’t usually have a choice with them.
That said, the best way to use credit cards is making a plan, so you don’t pay any interest at all. You can accomplish this by paying your statement balance in full each month. If you don't carry any debt, you don't pay any interest!
Choose what's best for your finances when deciding variable vs fixed rate!
Ultimately, choosing a variable vs fixed rate loan depends on your individual goals, expectations, and risk tolerance. Weigh all the pros and cons, make a plan to pay off debt, and move forward with the option that feels comfortable for you.