Fixed-rate and variable-rate loans each have advantages and tradeoffs, and the right choice depends less on trying to predict the future and more on understanding your own financial situation. With a fixed-rate loan, the interest rate stays the same for the life of the loan, providing predictable payments and protecting you from rising interest rates. With a variable-rate loan, you take on the interest rate risk yourself. In exchange, you typically receive a lower initial interest rate, and you may come out ahead if rates remain stable or fall.
The key question is not which option is always better but whether you can comfortably handle the worst-case scenario. Many variable-rate loans have caps that limit how much the interest rate can increase, but borrowers should still understand exactly how those caps work and what higher payments would mean for their financial plan. Fixed-rate loans often make more sense for large, long-term obligations like mortgages, especially when monthly cash flow is tight or predictability is particularly important. Variable-rate loans, however, can be a reasonable choice when the loan will likely be paid off quickly or when borrowers expect to own an asset for only a short period of time.
Adjustable-rate mortgages (ARMs) provide a good example of how loan terms can be matched to a particular situation. Someone who expects to move within five years may benefit from a lower rate with a 5/1 ARM rather than paying for a 30-year fixed mortgage. While variable-rate loans have earned a bad reputation during periods of rapidly rising interest rates, such as in 2022, they are not inherently good or bad. The important thing is to understand the loan terms, evaluate the risks, and avoid taking on debt or interest rate exposure that does not fit your goals, timeline, or tolerance for risk. Trying to accurately predict future interest rates is no easier than trying to predict the stock market, so building a sound plan is usually a better strategy than trying to make the perfect forecast.
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Dr. Jim Dahle:
Let's talk for a minute about two different types of loans: fixed versus variable interest rate loans.
What's a fixed-rate loan? It's simply a loan where the interest rate stays the same for the entire life of the loan, so the monthly principal and interest payment remains predictable. It's the same payment month after month after month for however long the loan term is, whether it's three years or 30 years. Same, same, same, same, same.
It's a nice benefit. Essentially, you're paying for the lender to run interest rate risk because, as interest rates change, that's either more beneficial or less beneficial to the lender, but it's all the same to you. You're basically protected from interest rate risk.
On the other hand, a variable-rate loan is where you take on the interest rate risk. The interest rate on this loan can change over time. If interest rates go up in general, your interest rate goes up and your payments become larger. You still pay it off in the same length of time, but you might be paying more interest every month.
On the other hand, if interest rates go down, more of your payment is going toward principal, and so you actually pay the loan off faster.
This is a difficult decision for a lot of people. They start going, well, should I take a variable rate or should I take a fixed rate?
The truth is, a variable rate usually has a lower rate, at least initially. Because you're taking on more risk, you should get a lower rate. There should be a benefit to you for taking on that interest rate risk so the lender doesn't have to. You're accepting the possibility that rates will go up while you still have this loan.
But if they don't go up, which they often don't, or, better yet, if they go down, you actually come out ahead with a variable-rate loan. It's a bit of a trade-off. You're giving up certainty in exchange for maybe a little bit lower cost on your borrowed money.
So what do you really have to ask yourself? You have to ask whether you can afford the worst-case scenario.
A lot of times, a variable interest rate might have a cap. Maybe you're starting out with a loan of 3.5%, and it can go up every year by as much as 2%, but it never goes higher than 10%.
Well, can you afford those payments at 10%? If you can, then maybe it makes sense for you to take a variable-rate loan. If you can't, and that would be devastating to your financial situation, keep you from accomplishing your financial goals, or would just irritate you a lot, then pay the lender to take that risk and take a fixed-interest-rate loan instead.
Maybe instead of getting 3.5%, you get 4% or 4.5%, or whatever. This is the same whether we're talking about student loans, mortgages, or car loans. There can be fixed-rate and variable-rate loans for all of these things.
People often use a fixed-rate loan for long-term home ownership because interest rates are almost surely going to go up at some point while you own a home for 15, 20, or 30 years. A lot of people get a fixed-rate mortgage because of that.
It's also a relatively large payment in the financial life of most people, and so the consequences of that rate going up are much higher than the consequences if your car loan went up a little in interest rate and you're going to have it paid off in six months anyway.
Maybe that's not as big a deal compared to a mortgage, where you might be making 25 years of payments at a higher interest rate. The longer the loan is going to be, the larger a piece of your financial life it's going to become.
If you highly value predictability, maybe a fixed-rate loan makes a little more sense for you. It definitely makes sense if you have very tight monthly cash flow.
But a variable-rate loan can make sense as well, especially if you don't expect to have it for very long. A lot of times, people use an ARM mortgage, an adjustable-rate mortgage, when buying their home.
For example, if you knew you were only going to be in the home for five years, you might get a 5/1 ARM. What that means is that the rate will be fixed for five years, and then it can change once a year after that.
Well, if you're only going to be there for five years, a 5/1 ARM is exactly the same as a fixed-rate loan. I mean, I guess there's a risk you might stay there longer than five years and the interest rate might go up. But if you're pretty darn sure you're only going to be there for five years, a 5/1 ARM might be a discount compared to a 30-year fixed mortgage, and so that might be a good way to go.
There are 3/1 ARMs, 1/1 ARMs, and 7/1 ARMs, so you can sometimes pick that period and get a little bit of a discount compared to what a 30-year fixed mortgage might cost.
Variable interest rates get a bad rap, and that's because every now and then there's a period of time like 2022, when interest rates went up 4% in about six months. It was the greatest, largest, fastest rise in interest rates I think the U.S. has ever had.
Of course, bonds had a terrible year because the value of a bond goes down when interest rates go up. Those who were borrowing money at variable rates didn't have a very good year, either. They did not enjoy 2022 at all.
In fact, a lot of people who had borrowed a little too much money at variable rates got into trouble. Many real estate investments that had done this got into trouble, and they had to call capital from their investors or scramble to refinance into anything they could find that would allow the investment not to completely blow up.
So variable interest rate loans get this reputation as being something to always avoid. I don't think you always have to avoid them. You simply need to pay attention to the worst-case scenario.
Can you handle the worst-case scenario? If you can't, maybe it's time to lock in that interest rate and use a fixed-rate loan rather than a variable-rate loan.
On average, though, most of the time you actually come out ahead with variable-rate loans, and you'll see that in lots of spaces. Real estate investing is one example. Business loans are another. A lot of times, you can't get the money unless you accept the interest rate risk.
My point is that you need to look beyond the initial rate. You need to understand how any adjustment caps work, what the rate ceilings might be, what the worst-case scenario is going to be, and evaluate the real cost and your ability to take on that interest rate risk.
Don't take on debt you don't understand. Don't take on interest rate risk that you don't understand or can't handle.
Make sure you match the loan structure, when you do have to borrow money, to your financial plan, your timeline, and your risk tolerance rather than trying to guess future interest-rate movements. Trying to predict interest-rate changes is about as difficult as trying to predict the movements of the stock market.
It's not a game you should try to play. If you have a crystal ball that works well enough for you to do that, you should be a gazillionaire managing other people's money rather than trying to figure out what to do with your loans.
Hope that's helped as you decide whether to use fixed-interest-rate or variable-interest-rate loans.
The White Coat Investor Podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
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