Are you willing to accept unexpected interest rate changes in return for a lower starting rate? This is the trade-off one must consider when choosing to pursue a variable vs. fixed rate loan.
Variable interest rate loans, also known as floating rate loans, are loans in which interest rates change based on market fluctuations. Variable interest rates are determined by two components: a benchmark and a spread. A variable benchmark is used to price macroeconomic risk, and a fixed spread is used to assess the risk of lending to an individual borrower.
Lenders usually peg the benchmark to an index such as the London Interbank Offered Rate (LIBOR) or an internal rate like the Marginal Cost of fund-based Lending Rate (MCLR). Both are used to price market risk and transfer it to the borrower. As the economy overheats and rates rise, so does the cost of a variable rate loan.
Benchmark rates fluctuate based on local and global economic factors. Below is an example of 3-month LIBOR rates and how they have changed since 2000. Usually, rates rise in the build-up to a major economic event such as the 2008 financial crisis. After the crisis, LIBOR dropped and was consistently low from 2010 to 2017. However, rates then more than doubled in a single year: from around 1.15% in April 2017 to 2.3% in April 2018.
A fixed rate loan offers borrowers a consistent monthly payment amount. The lender absorbs the impact of macroeconomic changes and never increases your interest rate. In fact, some lenders will even offer you interest rate discounts as a reward for timely repayments and academic success. However, this means that fixed-rate loans can have a higher starting rate than variable rate loans.
Deciding between a fixed rate loan and a variable rate loan involves assessing one’s own risk tolerance, among other factors. Remember, if you choose a variable rate loan, the interest rate you start off with is not necessarily the rate that will be present throughout the life of your loan.
Anantya Sahney is a former Leadership Development Program Analyst at MPOWER Financing. His prior work experience was primarily focused on investment management, and he became interested in financial services while interning at an asset management firm. Anantya recently graduated from Tufts University with a B.A. in Economics and History.