Before deciding to take out a loan, make sure you know your options. Not every loan is the same, and different loans can benefit your financial situation in different ways.

When considering the interest rate, you can choose between fixed-rate and variable-rate loans. Both options have their benefits and drawbacks, and choosing one depends on your unique situation, preferences, and credit history.

What Is a Variable-Rate Loan?

Variable-rate loans come with an interest rate that changes throughout the repayment period. In comparison, fixed-rate loans have an interest rate that stays the same during the entire life of the loan.

The interest rates on variable-rate loans change depending on the current financial markets. When the economy grows, the rate may rise, and when it shrinks, the rate can fall. That leads to a lower or higher payment on your loan.

How Do Variable-Rate Loans Work?

Variable-rate loans are tied to an underlying benchmark rate or an interest rate index. Financial institutions use benchmark rates to determine the cost of lending, and these rates depend on market fluctuations.

Two of the most common benchmark rates are The London Interbank Offered Rate (LIBOR), and the Prime Rate. Lenders use these rates as a baseline when determining their own interest rates. 

As with other borrowing options, an individual interest rate also depends on the borrower’s credit score, loan type, and their specific lender. Borrowers with better credit scores can secure loans with more favorable terms, and higher loan amounts.

Variable-rate loans can carry a higher risk for borrowers, because the interest rates fluctuate depending on economic trends.

What Are Interest Rate Caps?

Lenders have set caps to help protect borrowers from significant interest rate fluctuations. However, your monthly payment can still go up or down, even with interest rate caps.

Some variable-rate loans such as adjustable-rate mortgages have an initial period where the interest rate is fixed. After that, it follows the benchmark rate.

There are three different caps:

  • The initial cap, which decides how much interest rates can change during the first adjustment period.
  • The periodic cap, which determines how much the rate can change between subsequent adjustment periods.
  • The lifetime cap, which determines how high the interest rate can go during the entire duration of the loan. 

Even though these rates protect the borrowers, your payment can still increase. For instance, let’s say a fixed-rate loan has an interest rate of six percent; the cap for a variable-rate loan is set somewhere around 12–13%, meaning you could potentially pay twice as much interest.

The bigger the risk, the bigger the reward. There is no risk with fixed rates, but also no reward. You know how much you have to pay, which is why most borrowers choose this option.

With variable-rate loans, your monthly payment can go up or down. Sometimes borrowers with a variable-rate loan will end up paying less over time than they would have with a fixed-rate loan. However, it is hard to predict whether these trends will remain the same.

That’s why it’s best to familiarize yourself with all options and see which one works best for you.

Different Variable-Rate Loans

The most common loans with variable-rate interest include:

  • Adjustable-rate mortgages (ARM) — Most ARMs have an initial three or five-year period where the interest rate is fixed. After that, it follows the benchmark rate and market fluctuations.
  • Private student loans — While most student loans provided by the government come with fixed rates, some private lenders offer adjustable-rate student loans. 
  • Credit cards — Credit cards come with an APR that is mostly tied to the Prime Rate. Keep in mind that your credit card rate can change without prior advance notice.
  • Personal loans — Even though personal loans come with fixed interest rates, some lenders offer variable-rate options.

The Bottom Line

Variable-rate loans come with a lower initial interest rate, because fixed-rate loans usually have a higher rate to account for future market fluctuations.

If you need a short-term loan, adjustable-rate loans can be a great option since they start with lower costs. For instance, if you want a mortgage but plan on selling your real estate, or refinancing a loan after a short period, you could consider variable-rate loans.

CreditNinja is an online lender who offers personal loans. Our loans have competitive interest rates and flexible repayment options. Apply today and see if you qualify for a personal installment loan from CreditNinja.

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