What is the difference between a fixed and a variable interest rate?

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What is the difference between a fixed and a variable interest rate?

A fixed interest rate means that the rate of the finance charge does not change throughout the duration of the extension of credit. For example, an automobile dealer may offer a loan for an automobile at 4.9% interest rate for 24 months; this means the interest rate is fixed at 4.9% for the duration of the loan (which is an installment closed-end credit loan).

Under a variable rate loan, the finance charge is determined by an index, such as the “prime rate” published nationally each quarter for short term loans charged by banks. This form of loan enables the lender to charge an interest rate that reflects current market conditions. Many credit card issuers charge a base interest rate (such as 4.9%) plus the indexed rate (such as prime rate) to assure them adequate return on the loans that they extend. This mean your payments could decrease over the course of the loan, but they might also go up suddenly.

When shopping for credit, keep in mind that there is a difference between fixed and variable rates. Some lenders now extend credit on a fixed basis, but only for a short time, after which the interest rate becomes variable. It is important for you to read the fine print of the contract to know how the interest rate will be set and how it may change.

There are advantages and disadvantages to each kind of loan. Variable rate loans often have additional options, like accelerated repayment without penalty that might be valuable to you. There is more flexibility with these loans and more competition among lenders that might keep rates down. Fixed rates, on the other hand, give you security and stability, and let you plan for the future with certainty.

To determine which is better for you, crunch the numbers, determine the amount of credit you will use over the life of the loan, and apply the applicable credit rate. You could discover that a higher initial APR will result in a lower finance charge over the duration of the loan.

It’s sometimes possible to split your loan into a variable/fixed loan hybrid. For example, you could split the loan 50/50 or 35/65. To decide if this is a good choice, you still need to crunch those numbers and find out what fees and penalties apply.

(Reviewed 10.31.2008)

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