Do you plan to own a home? Or a car? Perhaps your small business needs a large sum of money to get off the ground? For all of these large, expensive purchases, society has come together to offer a solution for responsible individuals who can handle their debts. For those who need to borrow a large sum and are capable of repaying that sum (and more) over time, there is an option. Enter the loan.
Understanding the Terms
At a barebones level, what is a loan? Essentially, a borrower receives assets from a lender and gradually repays that initial sum along with interest over time. But, you may not be familiar with all of the intricacies, advantages, and disadvantages of the fixed rate loan. So let’s start with the basics. First of all, what is a fixed rate loan? And what other alternatives are there?
The phrase “fixed rate” simply means that the interest rate won’t change. Every time you pay your monthly fixed rate loan bill, the total amount of principal and interest stays the same. This type of loan differs from its counterpart, the variable rate loan, also known as the adjustable-rate loan. The difference between a fixed rate and a variable rate revolves around interest.
With a variable rate loan, instead of paying a monthly amount based on a stable, non-changing interest rate, you’ll pay a varying amount based on an interest rate that fluctuates with the current market. Because the interest rate may change, a variable rate may allow you to pay less than you would on a fixed rate, but it could also increase and cost you more than you might otherwise have to pay.
It is important to keep in mind that while a fixed rate loan has the same interest rate throughout the life of the loan, monthly payments can increase if your monthly payment includes taxes and homeowners insurance because taxes and insurance may change.
For those who prefer consistency and predictability over time, the fixed rate is the optimal choice. Because a fixed rate will never change, you’ll have a more accurate estimate of your financial burdens in the coming months or years. Perhaps you run a tight budget and can’t afford a risky rise in interest rates. In that case, this predictable certainty will work in your favor.
The fixed rate will let you avoid sudden increases in rates or catastrophic surges that would stick with you for years, making the fixed rate excellent for paying back a loan over a long time, such as ten or twenty years. For example, let’s say that interest rates skyrocket ten years down the road after starting to pay. In such a situation, the next ten years could be burdensome with a variable rate loan, but the fixed rate loan would prevent such problems from affecting you in the first place.
As long as you’re aiming for maximum savings and you’re able to pay more in case interest rates rise, the variable rate may suit your circumstances better than the fixed rate. Furthermore, the variable rate loan works better for those who hope to pay off their debt in a shorter time period – such as ten years or less.
Variable rates also tend to start out lower than their fixed counterparts, meaning that if the market stays constant or changes in your favor, you can expect superior savings. Variable rates can also change significantly, and may rise to uncomfortable extremes.
At the end of the day, the right type of loan for you depends entirely on your circumstances. Fixed rate and variable rate loans both have a fair share of advantages and disadvantages, and that’s why the decision ultimately falls to your own personal preferences. Do you prefer certainty, or do you prefer a chance at a better deal? No matter what you choose to do, make sure to explore all of your available prospects.
For further information about financial planning, loans, investing, or retirement, check out our blog on Finances.