Should You Choose Fixed-Rate or Variable-Rate Personal Loans?
Personal loans are flexible financial tools that have become more popular in recent years. You can take out a personal loan for nearly any reason.
Vacations, home improvement, and loan consolidation are just a few examples.
When you get a personal loan, the interest rate will determine the size of your monthly payment and the total cost of the loan.
A high interest rate results in higher payments and a higher total cost. A low rate means you’ll pay less each month and overall.
When you apply for a personal loan, you can apply for a loan with a fixed interest rate or a variable interest rate.
We break down the complicated parts of interest rates so that you can choose the right type of personal loan for yourself.
Fixed-Rate vs. Variable-Rate Personal Loans
Fixed Interest Rates
Fixed interest rates are relatively simple. When you are approved for a loan, the lender will tell you what the interest rate on the loan is.
This will be the rate for the entire life of the loan. It will never change.
What that means is you can calculate the cost of the loan to the penny, right from the moment you are approved.
You’ll know exactly how much you’ll pay each month, so you can easily budget for the expense.
Consider this example:
You borrow $20,000 for 5 years at a rate of 6%.
You’ll know that you’ll pay $386.66 each month, for the next 60 months. That means you’ll pay $23,199.36 over the life of the loan.
When you apply for the loan, you can specify whether you want a fixed or variable rate.
If you’re looking for a fixed rate loan, you can note that on your application.
Variable Interest Rates
Variable interest rates are different than fixed rates because they can change on a regular basis.
When your personal loan’s interest rate changes, it will affect both the size of your monthly payment and the total amount you’ll pay over the life of the loan.
If the interest rate goes down, your monthly payment goes down and so will the total cost of the loan.
If the interest rate rises, your monthly payment will increase, as will the loan’s total cost.
A significant rate increase could lead to a monthly payment that is unaffordable.
When Will Your Rate Change?
Usually, the interest rate on your personal loan will be tied to a benchmark, like the federal funds rate.
This is the interest rate is the rate at which major American banks lend to each other for overnight loans.
Governmental policies can affect the federal funds rate. When the government makes money easily available to banks, the rate will drop.
When the government tightens its economic policies and cash is scarce, this rate can increase.
Usually, your personal loan will have a rate that’s equal to a benchmark, plus or minus a percentage.
Usually, variable rate personal will charge less interest than a fixed rate loan that is opened at the same time.
This reduced rate is compensation for the fact that you’re accepting the risk that rates could rise.
You might come out ahead if rates hold steady or decrease, but variable rate personal loans can be dangerous. If interest rates increase by a lot, you might not be able to make your monthly payments.
Even with variable rate loans, your credit score, income, and financial history come into play when determining your interest rate.
Just know that other factors outside your control can cause the rate to change at any time.
When to Use a Fixed Rate Personal Loan
Fixed rate personal loans are best when you need a long time to pay the loan back.
If you expect to take five or more years to pay the loan back, you’ll probably want to go for a fixed rate loan.
This is because it’s nearly impossible to predict how interest rates will change over such a long period of time.
If you’re unlucky and choose a variable rate loan, you could get your loan at an all-time low, and rates will steadily increase over the life of the loan.
This will leave you with constantly increasing monthly payments. Had you applied for a fixed rate loan, you could have locked in a low rate for the life of the loan.
Fixed rate personal loans are also a good way to refinance your other variable rate debt.
If you want to turn your variable rate debt into fixed rate debt, a fixed rate personal loan is the way to go.
Even if your other loans have a fixed rate, you can guarantee savings by refinancing locking in a low rate with fixed interest personal loan.
When to Use a Variable Rate Personal Loan
Variable rate loans are usually better for short-term loans or loans that you plan to pay off as quickly as possible.
Fixed rate loans nearly always charge a higher rate than variable rate loans at the time the loan is opened.
Variable rates provide a lower rate because you take on the risk of rates increasing.
If you only expect to have the loan for a year or two, it’s unlikely that interest rates will increase by so much as to make the monthly payments too large to handle.
Variable rate personal loans are also good if you want to speculate on the future of the interest rate market.
- If you expect rates to go down in the future, choose a variable-rate loan.
- If you expect rates to increase, choose a fixed-rate loan.
Just remember the risks if you decide on a long-term, variable rate loan.
Change from a Fixed to Variable Rate, or Back, by Refinancing
One of the most common uses for personal loans is to consolidate or refinance other debts.
There’s nothing stopping you from refinancing a personal loan by opening another personal loan.
If you open a variable rate loan, and rates start to rise, you can refinance to a fixed rate loan to lock in your monthly payment.
If you have a fixed rate loan and you think rates are about to start dropping, you can refinance to a variable rate loan.
Just remember that refinancing isn’t free, so don’t plan to refinance your loan regularly.
How Does Interest Work?
Put simply, interest is a charge that you pay for the privilege of borrowing money.
No one will give you money for free, so the interest rate determines how much you must compensate the lender for lending you money.
The higher the interest rate on a loan, the more you are paying to the lender.
What this means is two loans with the same term, for the same amount, but with different interest rates will have different monthly payments and total costs.
The loan with the higher rate will cost more each month and overall.
How is the amount you’re charged calculated?
Each month, an interest charge is determined based on the unpaid portion of your loan.
So, if you originally borrowed $20,000 and have paid half of the loan off, you still owe $10,000. Your interest charge will be calculated based on that $10,000 balance.
Interest rates are quoted as a percentage rate per year.
Here's a simplified example to illustrate how interest is calculated:
Imagine a loan where you make payments once per year.
If you have a balance of $10,000 and the loan charged 4% interest, the interest charge at the end of the year will be $400, 4% of the $10,000 balance.
Had your balance been just $5,000, your interest charge would have been $200.
It ignores potential fees that you can be charged as well as compound interest: interest that is charged on accrued interest.
Wondering how much a personal loan might cost you? Check out our personal loan calculator to help you figure out your possible monthly payments and accrued interest:
How Is Your Interest Rate Determined?
The interest rate on your personal loan is the amount you’re paying the lender for the privilege of borrowing money.
Lenders want to be compensated more for taking on riskier loans, so they charge higher rates on higher risk loans.
Similarly, if you’re seen as a less risky borrower, the lender will charge less interest.
How do lenders gauge the risk of a loan?
Primarily, they look at your credit score and income.
If you have a good score, you’re seen as less risky and can get a lower rate on your personal loan. If you have a poor score, your loans will come with a higher interest rate.
Personal loans are so useful because of how flexible they are.
One of their many flexible features is the fact that you can choose a variable or fixed interest rate for your personal loan.
Fixed rate loans give you stability while variable rate loans can let you save some money, assuming rates don’t rise.