Finance
What's the Difference Between a Fixed Rate and a Variable Rate for Loans?
What you'll learn: How to choose between a fixed rate and variable rate when borrowing
EXPECTED READ TIME: 4 MINUTES
Taking out a loan often goes hand-in-hand with a big life event — buying a house or car, or attending school. Exciting as these pursuits may be, clearly understanding how interest rates affect a loan is key to taking on debt wisely.
What Is a Variable Rate?
A variable rate is an interest rate that changes based on fluctuating market conditions throughout the course of the loan term or as long as you have money in an interest-bearing deposit account like checking and savings.
How Does a Variable Rate Work?
When you apply for a variable rate loan, lenders have to calculate your interest rate using benchmark rates like the prime rate and the Secured Overnight Financing Rate (SOFR) (which replaced the LIBOR rate).
When you open an interest-bearing savings account, you will earn according to these fluctuations as well.
The prime rate (also called prime interest rate or prime lending rate) is the interest rate banks charge customers with the highest credit scores. It’s set by the Federal Reserve Board and based on the federal funds rate and SOFR, which determine the amount that financial institutions charge each other to borrow money overnight. (Banks and credit unions often borrow money for short terms to maintain their reserve balances.)
After lenders consult these benchmarks, they'll add a margin on top to calculate your rate. The higher your credit score, the lower that margin will be. The margin remains the same throughout the length of the loan, even though the interest rate will change with benchmark rates over time.
The prime rate (also called prime interest rate or prime lending rate) is the interest rate banks charge customers with the highest credit scores.
Examples of Variable Rate Loans
Some types of loans are available with either a variable rate or a fixed rate, so in the following examples, you'll see some overlap.
Mortgages
Private student loans
Examples of Interest-Bearing Accounts With Variable Rates
Checking
Savings
Money Market
Bonds
What Is a Fixed Rate?
A fixed interest rate on a loan stays the same throughout the life of the loan, which means monthly payments will also remain the same amount over the loan term.
A fixed rate on an interest-bearing deposit account usually means you’ll earn at the same rate as long as the account is open. Fixed rates are common with certificate accounts, but you can find some regular savings accounts with fixed rates.
Fixed rates are common with certificate accounts.
How Does a Fixed Rate Work?
But how is that fixed rate determined? When a borrower applies for a fixed rate loan, lenders look to current market rates to set the rate, which again, won't change during the life of a particular borrower's loan.
However, since lenders base fixed rates on market conditions, as well as other loan features, the rate amount that's issued may change from borrower to borrower, depending on market status at the time of application.
Some lenders also offer a range of fixed rates based on borrowers' credit ratings. In this case, borrowers with higher credit scores often qualify for lower rates.
And while fixed interest rates create a more predictable payment plan, they typically tend to be higher than variable rates at the moment of loan approval.
When it comes to savings, fixed rates are often marketed as giving guaranteed returns, meaning you can plan ahead knowing how much you’ll have at the end of the year.
A fixed interest rate on a loan stays the same throughout the life of the loan.
Examples of Fixed Rate Loans
Common types of fixed rate loans include:
Examples of Earning Accounts With Fixed Rates
Certificates
Variable Rate vs. Fixed Rate: Which Should I Choose?
Factoring in your financial situation and personal preferences will help you decide whether a variable rate or fixed rate is right for you.
A variable rate loan might be the best fit for you if:
Short-term financing is your goal. If you plan on taking 10 years or less to pay off your loan, you'll likely pay less in total interest throughout your loan term.
You have an immediate need for a lower interest rate.
You have enough flexibility to plan for potential interest rate and monthly payment increases.
A variable rate checking or savings might be right for you if:
You just want to earn something on your money and don’t need to know exactly how much you’ll have at a given point in time.
You want easy access to your money
You want to take advantage of rising interest rates and offset rate hikes on loans you may also have out.
Choose a fixed rate on a savings or checking account if you want to plan ahead and you don’t want any surprises.
You might choose a fixed rate on a loan if:
Certainty is a priority. You feel more comfortable knowing what your exact monthly loan payment will be — and that it won't change over the life of your loan.
You would rather not have to budget for potential rate hikes and increased monthly payments.
You anticipate taking approximately 10 or more years to pay off your loan and don't want to risk the chance of interest rate changes during that period of time.
You might choose a fixed rate on a savings or checking account if:
You want to plan ahead and you don’t want any surprises.
You don’t mind losing temporary access to your money while it sits in a certificate.
The Takeaway
Ready to select your rate? Just remember that weighing the advantages and drawbacks of variable and fixed rates with respect to your financial flexibility, comfort zone, and loan-payoff timeframe can help you make an informed decision.
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