Last week, I talked about good interest, and how you can put your money to work. Continuing this theme, today, I’ll be talking about the two different kinds of interest rates: variable and fixed rates.
To begin, remember that interest is simply the fee a borrower pays to the lender when they take a loan. The fee is usually a percentage of the total loan amount. This description of interest stays the same in the majority of cases. However, what tends to differ from loan to loan is what the percentage paid is. In the case of fixed-rate loans, the percentage you pay stays the same throughout the term of the loan. Variable rates, on the other hand, vary.
Like I mentioned earlier, interest is simply the payment a borrower makes to the lender in exchange for a loan. It’s present in every single kind of loan, including credit cards, mortgages, auto loans, student loans, and so on. Interest can also be earned by me and you; like I discussed last week, individuals can also earn interest by keeping their money in certain accounts and products, like certificates of deposit.
In most situations, when we talk about interest, we’re referring to a fixed rate. This means that the percentage you have to pay/get paid stays the same for the entire term of the loan. So, if you take out a fixed-rate loan at 5%, you will pay 5% every payment period for the term of the loan. This 5% will not change even if the Federal Reserve (the bank of the US government) increases rates.
Fixed-rate loans are good for those who expect overall interest rates to rise in the future and those who can afford their loan at the current rate but might not be able to afford their loan if rates rise. By taking a fixed-rate loan, they will never have to pay a higher rate. However, you also don’t get the chance to pay a lower rate if overall interest rates drop. So, while they limit their downside (protect themselves from increased rates), they also limit their upside (prevent themselves from taking advantage of lower rates). This can be changed, however, if they take out a new loan like many do when it comes to mortgages.
Variable interest rates are the opposite of fixed interest rates: the rate is not predetermined. Instead, the percentage you pay (the rate) fluctuates over time based on changes on an index or benchmark. This benchmark/index usually reflects the overall market interest rate for a specific type of loan based on changes made by the Federal Reserve. The Federal Reserve announces an interest rate based on the economic environment and banks base their rates on the Fed’s rate. The Federal Reserve does change rates somewhat frequently and bases its rate on how the country’s economy is doing.
When you have a variable interest rate, the amount you owe changes every time the Federal Reserve changes its rate. This can be both beneficial and harmful. In times of economic distress, like during the Covid-19 pandemic, the Federal Reserve dropped rates significantly so citizens can borrow money easily and put that money back into the economy. This was done to stimulate the economy. This would have been beneficial to those with a variable rate loan because their interest rate would have also dropped. Those with a fixed-rate loan would not have been able to enjoy this drop in rates.
It's important to remember the inverse also applies. When the Federal Reserve raises rates, to combat inflation, for example, those with variable rate loans would also have to pay more in interest, while those with fixed-rate loans will be unaffected.
Deciding between a fixed-rate loan and a variable rate loan is dependent on your situation and outlook. If you are content with the rate being offered for a fixed-rate loan or if you’re concerned with rates rising in the future, a fixed-rate loan is likely what you're looking for. Similarly, if you're expecting rates to fall in the future, or if you're not worried about rates changing at all, a variable rate loan may be suitable for you. Remember to consult a registered financial advisor before making this choice.
Some loans, like home loans, allow you to choose between a fixed and variable rate. Other loans, like federal student loans, only offer one choice (fixed rates). You will also have to pay variable rates on credit card debt, which is already significantly higher than normal (often 20% +), and private student loans.
To summarize, variable rate loans have their interest change over time-based on changes made by the Federal Reserve, while fixed-rate loans stay at the same rate for the entirety of the loan. Deciding between these two can be a difficult decision and depends on your outlook for the future, however, I hope this article helped you gain a deeper understanding of interest rates and how they differ.
Thanks for reading, and I’ll see you next week!