What Is the Danger of Taking a Variable Rate Loan: Fixed vs Variable Interest Rates?
In our current world, shopping for loans has been made easier than ever. There are a lot of loan options, each one having different approaches and procedures.
Among these options is the variable rate loan. Not all people are conversant with this loan. So here is a brief definition of a variable interest rate: a loan is characterized by unpredictability.
Therefore, it is essential to do your research, get the appropriate information, and make an informed decision.
Some financial products that have variable interest rates include:
- Credit cards
- Adjustable-rate mortgages
- Auto loans
- Private student loans
One might wonder, is this type of loan any good? And what is the danger of taking a variable rate loan?
But before we get there, it is vital to first understand and differentiate it from the others.
What Is the Difference Between Fixed and Variable Interest Rates?
Contrary to a variable rate loan, a fixed-rate loan has a constant interest rate throughout the borrowing period. This means that the cost you pay for the loan is stagnant throughout the borrowing period; it can never change even when the market fluctuates.
Loans with such standardized rates include car loans, online personal loans, and many others. Most of the installment loans online services also fall under this category.
One of the most common fixed interest rate loans is the thirty-year fixed-rate mortgage. Most property owners opt for this loan because it is easy to manage and budget for every month. This comes as a relief to consumers with stable but tight budgets since they will be protected from rising interest costs.
Most Americans have mortgage debt as one of their main sources of debt in the nation.
On the other hand, the variable interest rate loans are loans where the changes in interest rates dictate the interest rate, meaning that it will keep changing. These rates are pegged to a reference and a margin, which the lender determines. This loan is often referred to as an adjustable loan, with an initial interest rate lower than the fixed loan.
The main difference that settles the fixed rate vs. variable rate loans lies within the interest rate. One can predict the amount to be paid by the consumer, and the other has to calculate concerning the benchmark rate.
How Variable Rates Work
That said, how do variable rates work?
First, every loan has to be tied to one or two reference rates. Most financial institutions rely on two references: The London Interbank Offered Rate (LIBOR) and the Prime Rate. These are ideal benchmarks to determine the value of money at any point of the month.
Using these baselines, lenders can now add a margin on top of the reference rate and calculate the rate at which the customer will pay their monthly installment.
How Often Does a Variable Interest Rate Change Over the Borrowing Period?
Reference institutions such as LIBOR dictate the rate at which your interest loans change every month. This means that your rate will typically change in tandem to the reference, which can happen several times every year. These fluctuations can happen even happen once every year.
Before you close a loan, the law states that you should be fully educated about the interest rates and other additional features. Some lenders will also notify you whenever a change in rate goes into effect.
What Are the Pros of Variable Interest Rates?
The Interest Rates Are Relatively Lower Than Fixed Interest Rates
Compared to the fixed interest rates, the variable interest rates loans have lower interest rates, especially during the early months of the repaying period. The rates are normality set lower. Then, they can increase or decrease depending on the fluctuation of the value of money according to the reference institution.
This means that if you opt for the variable interest rate loans, you might end up paying less than you would have if you chose to go the fixed-rate way.
More Features Are Available
Unlike fixed-rate loans, this type of loan has more options for your to choose from. For example, you can find lenders who offer the offset account option. This acts as a sub-account that can be connected to your loan account to help you cut down on the interest rates you are to pay.
Another feature that can be availed for you is the flexibility where you can make extra payments to repay your loan. This can allow you to pay off your debt much faster, further reducing the total repayment cost.
The Borrower Benefits When the Interest Rates Drop
The interest rates don’t always increase; they can also reduce, sometimes even drastically. Your repayment amount will decrease significantly in such a scenario, allowing you to save money on it.
What Are the Cons of Variable Interest Rate Loans?
They Are Pretty Unpredictable
As we have seen, the interest rate at a specific point of the borrowing period is dictated by a fluctuating reference situation. Thus, you always have to wait until the repayment day to know the amount of money you should pay as an installment. This makes it hard for you when budgeting for the installment money as you don’t know the exact amount expected from you.
The Rates Can Go Extra High
One danger of taking a variable rate loan is that as the benchmark institution’s interest rates rise, so is the amount you pay. Sometimes these rates rise to the point that you might find it challenging to keep up with the payments, putting you under financial stress.
The Lender Finds It Hard to Predict Future Cash Flows
The fact that the rates can’t be predicted also makes it hard for the lenders to project their cost flow. This can affect them financially, especially when giving out more loans to customers.
The Bottom Line
Whenever you want to take a loan, be it an auto title loan or a variable rate personal loan, understanding the difference between variable and fixed interest loans is one of the most vital stages.
You have to do in-depth research of the two loan types, weigh your options, and choose what you feel is right for you. Those who prefer predictable payment go for the fixed-rate loans, while those who believe that the rates will decline go for the variable rate loan.
References:
Thomas Morgan is a treasured writer and a financial expert for our website. Readers acknowledge his mastery over every topic and follow him on other platforms for important information. He is also the founder of lendertraining.com, QuickStart Publications, and MortgageManuals.com. In 1983, Thomas got into the mortgage business after completing his academics at the New York University. He also collaborates with big names such as American Residential-Chase, Fannie Mae, Citibank, and his entity known as Hamilton Mortgage. His grip over lending topics is evident because he has handled multiple positions such as underwriting, processing, quality control, closing, and many others. Morgan is also equipped with the essential requirements and works in sync with the company operators for training manuals, procedures, and other operating policies.
Applying does NOT affect your credit score!
No credit check to apply.