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

Imagine you're planning a big trip: You need to choose between booking a hotel with a locked-in nightly rate or one where the price fluctuates based on demand. Your decision will impact your budget, your stress level, and ultimately, your entire experience. Now, swap out that hotel scenario for a loan, and you've got the essence of choosing between fixed and variable interest rates.

These two types of rates are fundamental to how loans work, influencing everything from your monthly payments to the total amount of interest you'll end up paying. Whether you're dealing with a mortgage, car loan or personal loan, understanding the difference between fixed and variable interest rates can help you make savvy financial decisions that fit your life and goals.

What Are Fixed Interest Rates?

A fixed interest rate stays the same for the duration of your loan. The interest rate you initially agree on with your lender won't change, no matter what happens to interest rates in the market as a whole. This consistency can be a big plus when you're planning your finances.

Pros of fixed interest rates

• • Stability and predictability. The biggest advantage of a fixed interest rate is its consistency. Since the rate does not change during your loan term, your monthly payments will always be the same, making it easier to budget and plan ahead.
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• • Protection against rate increases. With a fixed rate, you're safe from interest rate hikes. If market rates go up, your rate stays the same during your loan term, which could save you money over time.
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• • Easier financial planning. Fixed interest rates make it simpler to predict your financial future. Knowing exactly what you'll pay each month helps with managing your cash flow and saving for other goals.

Cons of fixed interest rates

• • Higher initial rates. Fixed interest rates are often higher at the outset than variable rates. That's because when you lock into a fixed rate, your lender bears the risk of potentially losing out on higher payments from you if rates go up. The higher initial rate offsets their risk somewhat.
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• • No benefit from falling rates. On the other hand, if market interest rates drop, you won't benefit because your rate is locked in. This could mean you end up paying more in interest compared to a variable rate loan.

What Are Variable Interest Rates?

Variable interest rates, also known as adjustable or floating rates, change over time. They're based on an underlying benchmark rate that reflects current economic conditions, as well as the interest rate set by the Federal Reserve. Variable rates usually start lower than fixed rates at the beginning of the loan period but can go up or down, reflecting what's happening in the broader financial market.

Pros of variable interest rates

• • Lower initial rates. Variable rates often begin lower than fixed rates, which can mean more affordable payments when you first take out your loan.
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• • Benefit from decreasing rates. If market rates go down, your rate can drop too, potentially lowering your monthly payments and overall interest costs.
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• • Potential for savings. If rates stay stable or decline over the loan's life, you could save money compared to a fixed-rate loan.

Cons of variable interest rates

• • Volatility and risk. The main downside of variable rates is their unpredictability. If market rates increase, so do your interest rate and monthly payments, which can lead to financial strain.
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• • Harder financial planning. It's more difficult to predict your long-term costs and to budget effectively with variable rates. Sudden rate increases may affect your financial plans and lead to higher expenses.
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• • Potential for higher long-term costs. If interest rates rise significantly over the loan term, the overall cost of borrowing can end up being higher than with a fixed-rate loan.

How To Choose Between Fixed and Variable Interest Rates

Deciding between fixed and variable interest rates depends on several factors, including your financial situation, market conditions and how much risk you're willing to take. Below is a comparison to help illustrate the key differences.

	Fixed Interest Rates	Variable Interest Rates
Rate Stability	Stays the same throughout the loan term	Fluctuates based on market conditions
Monthly Payments	Predictable and consistent	Can change over time
Initial Rate	Typically higher	Typically lower
Financial Planning	Easier thanks to consistent payments	Harder due to payment variability
Risk from Rate Hikes	None	Higher monthly payments
Benefit from Rate Drops	None	Lower monthly payments
Overall Cost	Potentially higher if rates stay low or drop	Potentially lower if rates stay stable or drop

Here are a few other factors to consider when deciding between a fixed- or variable-rate loan or mortgage, according to your risk profile and individual circumstances.

• • Stability seekers: If you like stability and predictability, or if you have a tight budget with little room for payment increases, a fixed interest rate can help you sleep at night.
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• • Risk-takers and savvy planners: If you are comfortable with some level of risk and keep an eye on market trends, or if you expect interest rates to go down, a variable interest rate might be more advantageous.
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• • Short-term borrowers: If you plan to pay off your loan quickly or refinance in a few years, a lower variable rate might offer immediate savings.

Put Your Best Interest at Heart

Fixed and variable interest rates each have their advantages and disadvantages. Understanding these differences and considering your financial situation, your risk tolerance and market conditions can help you make the best choice. Making an informed decision now can pave the way for a secure and successful financial future. So, take the time to evaluate your options, possibly consult a financial advisor and choose the interest rate that best aligns with your goals.

Curious to know how your level of mortgage, credit card and other debt stacks up to your peers? Find out the average American debt by age.

 

Tamar Satov is a freelance journalist based in Toronto, Canada. Her work has appeared in The Globe and Mail, Today's Parent, BNN Bloomberg, MoneySense, Canadian Living and others.