Fixed vs. Variable Interest Rates - What's the Difference?

When you take out a loan, let’s say for $10,000, you don’t just pay back $10,000. In most cases, you will pay back the amount you borrowed—that $10,000—plus interest. The interest you pay on your loan is what the lender charges. Interest pays the lender for the work they put into underwriting and funding your loan. 

But not all interest rates are the same. When you get a loan, you may be charged a fixed or variable rate. Understanding fixed vs. variable interest rates can help you anticipate your expected payment and ensure you plan appropriately for the responsibilities related to your loan.

Read on to ensure you are in the know when it comes to short-term loan interest rates.

Understanding Interest Rates 

Interest rates represent the cost to borrow money and are expressed as a percentage of the principal, the amount borrowed. This rate is what determines the extra amount you'll pay over the loan's life or the earnings from savings and investments. Interest rates are applied in various ways depending on the product; for example, loans and credit lines often have an interest rate that affects the monthly payment, while savings accounts have a rate that dictates the earnings on deposited funds.

Lenders determine interest rates based on several factors, including the risk of lending, the cost of funding the loan, the expected inflation rate, and market conditions. Creditworthiness plays a super important role: borrowers with higher credit scores typically receive lower interest rates due to perceived lower risk. Additionally, external factors such as central bank policies and economic conditions—such as the current inflation rate—heavily influence the rates lenders offer.

For consumers, interest rates influence decisions on buying homes, taking out loans, and using credit cards. High rates deter borrowing and spending, while low rates encourage it, promoting economic growth. Similarly, interest rates affect investment decisions; they determine the return on bonds, savings accounts, and other financial instruments. 

What is a Fixed Interest Rate?

We mentioned earlier that interest rates come in two forms: fixed and variable. So, what is a fixed interest rate? A fixed interest rate, as the name implies, remains constant throughout the duration of the loan or credit agreement. Unlike variable rates, this unchanging rate means that the interest percentage does not fluctuate with market conditions or index changes. This stability provides borrowers with a predictable payment schedule.

Pros of fixed interest rates include:

• Predictability and Stability in Payments: Since the rate doesn't change, the monthly payments remain the same, allowing for easier management of personal finances.
• Easier Budgeting and Financial Planning: Fixed payments facilitate better budgeting by eliminating surprises in payment amounts, even if economic conditions change.
• Protection from Rate Increases in a Rising Rate Environment: A fixed-rate agreement shields borrowers from increases in interest rates. If the market rates go up, the fixed-rate agreement keeps the cost of borrowing the same, providing significant savings over time.

What is a Variable Interest Rate?

Now that you understand what a fixed interest rate is, you can probably guess what a variable rate is. You guessed it—it isn’t fixed. Unlike a fixed one, a variable interest rate changes periodically over the loan's duration based on an underlying benchmark or index such as the prime rate, LIBOR (London Interbank Offered Rate), or other economic indicators. This means that your interest payments may increase or decrease depending on fluctuations in the overall financial market or policies set by central banks.

How Variable Rates are Determined

Variable interest rates are tied to these indices, which reflect the cost of borrowing money in the financial markets or the economy's overall interest rate environment. Lenders add a margin to the index rate to set the actual rate charged. As the index rate varies with economic conditions, so does the variable rate on the loan.

Pros of variable interest rates include:

• Lower Initial Rates: Variable rates are often lower than fixed rates at the loan's inception, making the loan more affordable initially.
• Potential Savings if Interest Rates Decline: If the overall interest rate environment drops, the variable rate will also decrease, reducing the amount of interest payable and potentially decreasing the monthly payments.

Cons of variable interest rates include:

• Uncertainty and Potential for Rate Increases: The biggest downside of variable rates is the uncertainty they introduce into financial planning. If interest rates rise, the variable rate will also increase.
• Budgeting is More Complicated Due to Fluctuating Payments: Because payments can vary with changes in interest rates, budgeting and financial planning can be more challenging for individuals with variable-rate loans—especially if you are one of the 78% of Americans living paycheck to paycheck. This fluctuation can make predicting financial needs and managing long-term financial commitments difficult.

Comparing Fixed and Variable Interest Rates

When comparing fixed and variable interest rates, you must consider your financial situation and goals. Imagine a scenario where you secure a $10,000 loan. You might have higher initial payments with a fixed rate, but these remain consistent regardless of economic changes. On the other hand, you might start with a lower payment with a variable rate, but these can increase if interest rates rise.

Tips on choosing between fixed and variable rates:

• Financial Goals and Risk Tolerance: A fixed rate might be more suitable if you prefer predictability and have a lower risk tolerance. However, a variable rate could offer initial savings if you are comfortable with some uncertainty and can handle potential rate increases.
• Economic Outlook and Interest Rate Trends: Consider the current economic environment and forecasts. Locking in a fixed rate could be beneficial if rates are expected to rise. Conversely, a variable rate might save you money if rates are expected to fall.
• Loan Term and Amount: A fixed rate can protect against the risk of rising rates over time for longer-term loans. For shorter durations or smaller amounts, the lower initial payments of a variable rate might be more appealing.

Selecting the right rate type involves balancing your financial stability, risk tolerance, and economic conditions to align with your personal and financial objectives.

Cash Store Offers Fixed-Rate Loans for Your Short-Term Financial Needs

If you need a short-term lending option, Cash Store can help. We offer installment loans designed to help you meet your financial goals. And even better, our loans come with a fixed rate, making them predictable and easy to budget.

To get started, complete our prequalification application.

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