Deciphering the language in loan applications can be confusing. You need to understand terms, fees, and what your monthly payment will be. One big decision you may have to make is picking the best interest rate type for your loan: fixed or variable.
Here’s the difference between both and what you need to understand about each before signing a loan.
What is a Fixed Interest Rate?
Fixed interest rate loans are loans that have an interest rate that stays the same for the duration of the loan. When you make monthly payments, it is the same amount every time.
This is a good option to set up automatic payments every month and you’ll know where your money is going. No matter what, your payments won’t change.
What is a Variable Interest Rate?
A variable interest rate loan changes based on the fluctuation of market interest rates. That means your payments can vary month to month depending on what the market does. You might get a loan with a low variable interest rate, but it could rise over time, meaning you could pay more in the long run.
Variable interest rates can be hard to plan for. Most of us can’t foresee how markets will shift over the course of our loans, so you might feel like interest rate fluctuation will hurt you. Not having a rate locked in means that it can go up or down, making payments unpredictable.
What to Consider When Choosing Your Rate
If you have the choice between a fixed interest rate and a variable interest rate, your decision might weigh on the loan terms themselves.
Longer loan terms mean paying more in interest in the long run. If you have a shorter loan term, you might consider the variable interest rate option since you could end up paying less in interest over time. But if the idea of paying more if the market interest rate changes, consider taking the fixed rate. Paying the same amount no matter what might give you peace of mind.
If you’re having a hard time making a choice, you might want to look at how your credit score could make the decision for you. The higher your credit score, the lower your interest rate will be.
Evaluate the loan you need from many lenders to see which ones offer you the best possible options. Aside from the life of your loan, think about the possibilities of fees that could be imposed. If you have a decent interest rate but you might get penalized for paying off your loan early, it might not be worth it in the long run. (At Earnest, we do not charge origination, prepayment, early payment, or extra payment fees.)
So Which is the Right Interest Rate Option?
It’s important to think about your needs before deciding which option is best for you. Everyone’s financial situation is unique and there really is no wrong way to choose — just a different way.
Ultimately, your decision should be based not just on the type of interest rate offered, but the loan you need, how long the loan life is, and what your budget can handle. Make sure you take into account your other financial responsibilities, like rent or a mortgage payment, utilities, and even student loans for you or your family. Think if you’re going to struggle to make payments alongside your other obligations and plan accordingly.
If you’re stuck between fixed versus variable interest rates, be sure to take all factors into consideration. If you’re comfortable with the possibility of rate fluctuation, variable interest rates might be a good idea — especially if you’re offered a low rate. However, it’s OK to choose a fixed interest rate. The comfort of having one regular payment that doesn’t change is a reliable choice.
Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.
Dori Zinn is a personal finance writer that focuses on handling credit and debt, smart budgeting, side hustles, loan management, and retirement.