Fixed vs. Variable Interest Rates: Definitions, Benefits & Drawbacks

What Is a Fixed Interest Rate?

A fixed interest rate offers stability, ensuring level payments throughout your loan's term, unlike variable rates, which fluctuate with market conditions. Understand the implications, calculation methods, and strategic choices involved in selecting a fixed or variable rate to better manage your financial planning.

Understanding Fixed Interest Rates

A fixed interest rate is attractive to borrowers who don’t want their interest rates fluctuating over the term of their loans, potentially increasing their interest expenses and, by extension, their mortgage payments. This type of rate avoids the risk that comes with a floating or variable interest rate, in which the rate payable on a debt obligation can vary depending on a benchmark interest rate or index, sometimes unexpectedly.

Borrowers are more likely to opt for fixed interest rates when the interest rate environment is low when locking in the rate is particularly beneficial. The opportunity cost is still much less than during periods of high interest rates if interest rates end up going lower.

Fixed rates are usually higher than adjustable ones. Adjustable or variable-rate loans often start with lower teaser rates, making them attractive when interest rates are high.

The Consumer Financial Protection Bureau (CFPB) provides a range of interest rates borrowers can expect at any given time depending on their location. The rates are updated biweekly, and consumers can input information such as their credit score, down payment, and loan type to get a closer idea of what fixed interest rate they might pay at any given time and weigh this against an adjustable-rate mortgage (ARM).

Calculating Fixed Interest Costs

Calculating fixed interest costs is simple. You only need to know:

• The loan amount
• The interest rate
• The loan repayment period

Remember that your credit scores and income can influence the rates you pay for loans, regardless of whether you choose a fixed- or variable-rate option.

Comparing Fixed and Variable Interest Rates

Variable interest rates on ARMs change over time. Initially, borrowers get a set rate for one, three, or five years. The rate adjusts on a periodic basis after that point. Such adjustments don’t occur with a fixed-rate loan that’s not designated as a hybrid.

For example, a borrower gets a 3.5% introductory rate on a $300,000, 30-year mortgage with a 5/1 hybrid ARM. The monthly payment is $1,347 for the first five years. After that, payments adjust with the benchmark interest rate.

If the rate adjusts to 6%, the borrower’s monthly payment would increase by $452 to $1,799, which might be hard to manage. But the monthly payments would fall to $1,265 if the rate dropped to 3%.

If, on the other hand, the 3.5% rate were fixed, the borrower would face the same $1,347 payment every month for 30 years. The monthly bills might vary as property taxes change or the homeowners insurance premiums adjust, but the mortgage payment remains the same.

Pros and Cons of Fixed Interest Rates

Fixed interest rates can offer both pros and cons for borrowers. Looking at the advantages and disadvantages side by side can help decide whether to choose a fixed- or variable-rate loan product.

Pros

Fixed interest rates provide consumers with some degree of predictability. This means that your monthly loan or mortgage payments remain the same for the lifetime of the loan. Even if conditions change and rates go up, your rate remains the same. As such, you won't have to budget for increases in your payments later on down the road.

When interest rates are low or near historic lows, a loan that comes with a fixed interest rate can become more attractive. Taking out a loan with adjustable or variable rates probably won't be a good option, especially since there's a risk that rates may go up in the future.

A fixed interest rate on a mortgage, loan, or line of credit makes it easier to calculate the lifetime cost of borrowing because the rate doesn't change. This allows you to budget for other expenses, including any extras like vacations or a new car. It also gives you the opportunity to plan for any savings.

Cons

Fixed interest rates tend to be higher than adjustable rates. Depending on the overall interest rate environment, it is highly possible that a loan with a fixed rate may carry a higher interest rate than an adjustable-rate loan.

You'll also want to consider declining rates when it comes to fixed interest rates. That's because if interest rates decline, you could be locked into a loan with a higher rate, whereas a variable-rate loan would keep pace with its benchmark rate.

Refinancing is another drawback. When you refinance your loan from one fixed-rate product to another of the same type or to a variable-rate loan, you could save money when rates drop. But it can be time-consuming, and closing costs can be high.

Real-World Examples of Fixed Interest Rates

Here are examples to illustrate how fixed interest rates work.

Assume you take a $30,000 debt consolidation loan to repay over 60 months at 5% interest. The monthly payment is $566, with total interest of $3,968.22. This assumes you don't repay the loan early by increasing your monthly payment amount or making lump-sum payments toward the principal.

Here's another example. Say you get a $300,000 30-year mortgage at 3.5%. Your monthly payments would be $1,347 and your total mortgage costs with interest included would come to $484,968.

The Bottom Line

Understanding interest rates is crucial for making informed financial decisions. Fixed interest rates provide stability and predictability, as they remain constant for the life of the loan, whether it's a mortgage, car loan, or line of credit. This allows for easier budgeting since monthly payments don't fluctuate.

However, fixed rates tend to be higher than variable rates, and you could miss out on savings if interest rates decline. Carefully consider your financial situation and market conditions when choosing between fixed and variable interest rate options.