Loans are taken out by individuals and corporations in order to meet long term or short term financial requirements. There are a number of factors that need to be considered when taking out a loan, such as interest rates, principal, the term of the loan and most importantly the amount of the loan. There are a number of options from which a borrower can choose his, depending on how he would like to pay off his loan. Fixed rate loans and variable rate loans are one such option. The article clearly explains what is meant by these terms and explains how they are similar and different.
Fixed Rate Loan
A fixed rate loan is a loan that has a rate of interest that is fixed for the entire lifetime of the loan. A fixed rate loan has an interest rate that is constant and, therefore, is less risky and more stable for the borrower. A borrower who takes out a fixed rate loan will know for sure the level of interest that needs to be paid periodically, which can help in cash flow management. A long term mortgage is the most common form of fixed rate loan, where the loan duration is usually longer (generally up to at least 30 years), which means that the borrower would have to pay more interest over the longer term of the loan.
Variable Rate Loan
As the name suggests, a variable rate loan is the exact opposite of a fixed rate loan. In a variable rate loan, the interest rate applied on the loan does not remain constant over the period of the loan. Instead, the interest rate keeps fluctuating in line with a market index. In a variable interest rate loan, the interest rates are prone to market changes and can be quite vulnerable to market conditions. This means that the lender can stand to pay lower interest rates or higher interest rates depending on the interest rate fluctuations.
There are, however, adjustment periods in which the interest rates can change. For example, if the loan taken out has an adjustment period of a year then the interest rate will be changed to market indexes every year, and this rate will be applied for the next year. Variable interest rates also have certain limits to the lows and highs that they can reach called ‘caps’. If the ceiling rate (highest that can be charged) and floor rate (lowest rate than can be charged) are between 3% and 11%, then the interest rate cannot be lower than 3% or higher than 11%.
What is the difference between Fixed and Variable Loans?
Which loan interest rate option you choose depends on the individual/organization’s requirements and preferences. Most entities favour a fixed interest rate approach since this will improve stability and certainty in the amount that should be set aside as interest. Variable interest rates are also used and can be risky or beneficial depending on the conditions in the market. A variable interest rate, unlike a fixed interest, can be riskier unless in a market environment with constantly decreasing interest rates.
Summary:
Fixed Rate Loan vs Variable Rate Loan
• A fixed rate loan has an interest rate that is constant and, therefore, is less risky and more stable for the borrower.
• In a variable rate loan, the interest rate applied on the loan does not remain constant over the period of the loan. Instead, the interest rate keeps fluctuating in line with a market index.
• Most entities favour a fixed interest rate approach since this will improve stability and certainty in the amount that should be set aside as interest.