When taking out a loan, it pays to weigh the pros and cons of a variable interest rate
- Variable interest rates make sense in specific situations, like when you plan to buy and sell a house in a few years or want to pay off a loan early.
- Variable-rate loans can be risky though because interest rates can go up.
- Fixed-rate loans are almost always more dependable and easier to budget for.
When it comes to borrowing money, one of the decisions you’ll be asked to make is whether you want a variable- or a fixed-rate loan. A variable interest rate is a rate that goes up and down over time. Because variable rates are tied to an underlying benchmark interest rate, they mimic what’s happening with that underlying rate. For example, the variable interest rate increases if the benchmark rate goes up.
While fixed-rate loans are more common, you may be surprised to learn that a variable-rate loan works best for you in certain situations. Here are four of them.
1. You don’t expect to keep a loan for long
Let’s say you’re moving to a new city but know you’ll only be there for two or three years. You’re buying a home and notice the variable interest rate is lower than the fixed rate. The less time you carry a mortgage with a variable interest rate, the less chance that the underlying benchmark will increase and your variable rate will go up. So it may make sense to go with a variable rate when you know you’re not going to hang on to the loan for long.
Another example would be if you’re expecting funds from an annuity, life insurance, or work bonus. If you borrow money in the months leading up to that big payday (and plan to pay the loan off with cash), a variable rate may save you money due to the lower interest rate.
2. You believe interest rates are going to decrease
Like the weather, interest rates can change by the day. If you’re borrowing money and all indications point to interest rates dropping, taking on a variable interest rate loan means your monthly payment may also decrease. That said if you’re wrong and the interest rate increases, you’ll see your payments go up.
3. You’re using the monthly savings to pay down the principal
Imagine you’re taking out a debt consolidation loan for $50,000. The fixed interest rate is 6%, and the variable rate begins at 4%. The loan term is 10 years. By taking on the variable interest rate, you’ll save about $50. If you plan to use those monthly savings to pay down the principal (the original amount you’re borrowing), you’ll not only pay the loan off early, but you’ll also save more than $1,200 in interest.
The fly in the ointment is that this plan only works if the variable interest rate does not rise before the loan is paid off. The longer you have a variable interest rate, the more likely the rate will increase.
4. Taking on a variable rate is the only way you can qualify for the loan
If you’re making a large purchase, like buying a home or piece of land, and you don’t qualify for a fixed-rate mortgage, you may be eligible for a variable loan with a lower interest rate and monthly payment.
However, if what’s standing between you and a loan is a slightly higher interest rate, you might want to reconsider the purchase — at least for now. The fact that you don’t qualify for the fixed-rate interest loan indicates that you may be taking on a more significant obligation than you can comfortably afford.
The bottom line is this: A variable-rate loan usually only makes sense in specific situations. A fixed-rate loan allows you to budget with the knowledge that your loan payments will not increase over time. If you can snag a low enough interest rate on a fixed-rate loan, it’s almost always the more dependable choice.