Published in: Personal Loans | June 10, 2019
Pros and Cons of Variable Rate Personal Loans
By: Christy Bieber
Variable rate personal loans can be a great option, but make sure they're the right choice for your situation.
Image source: Getty Images.
When you apply for a loan, the interest rate is one of the most important terms you agree to. The rate determines both your monthly payment along with the total cost of borrowing.
With many types of loans, including personal loans, mortgage loans, private student loans, and car loans, you’ll have a choice of a variable or a fixed rate. There are pros and cons of both variable and fixed rate loans, so you need to understand the differences and consider the relative advantages and disadvantages when deciding which type of personal loan is right for you.
Variable vs. fixed rate loans
Fixed rate loans are exactly what they sound like: They are loans with a fixed interest rate. The interest that you pay to borrow never changes throughout the life of the loan. If you get a personal loan with a 9% fixed interest rate, your rate will still be 9% one year, five years, seven years, or 10 years from now -- no matter what happens to market rates in the meantime.
Variable rate loans also have a name that describes what they are: loans with a variable interest rate, or an interest rate that can change during the time you have the loan. Variable rate loans don’t just change interest rates randomly on the whim of the lender, though. The loans can change rates on a fixed schedule, and the interest rate is typically tied to some financial index. For example, you might get a variable rate loan that moves up or down with the Prime Rate or with the LIBOR index.
When you apply for a variable rate loan, it’s important to understand how often the rate can change, as well as the maximum and minimum interest rates you could be charged for the loan. Knowing this information can help you to make an informed choice about whether a variable rate loan is a viable solution.
Pros and cons of fixed rate personal loans
Fixed rate personal loans have some significant advantages for borrowers -- but some disadvantages, too. Here are some of the pros:
- You’re protected from rising interest rates: Chances are good that interest rates will eventually go up over time, especially if you’re taking out a personal loan that will be repaid over a longer term, such as 10 years. A fixed rate loan will protect you from those potential rate hikes.
- You’ll always know exactly what your monthly payment will be: Since your payment will never change, you can easily determine if your personal loan is affordable for you and can make sure to budget to pay what you owe. There won’t be any surprise payment increases that make it difficult for you to afford repaying your loan.
- You’ll know the total cost of borrowing up front: Since you’ll know how much you’re borrowing, the loan term, and the interest rate, it’s easy to figure out the total amount of interest you’ll pay over the life of the loan. By knowing the total cost up front you can make a more informed choice about whether the cost of borrowing is worth it.
However, some of the disadvantages include the following:
- Your interest rate and monthly payment will generally start out higher than the starting rate on a variable rate loan: This means you could end up paying more up front than you otherwise would. You could miss out on several years of being able to make smaller payments at a lower monthly interest rate.
- Your rate won’t automatically go down if interest rates fall: While this is a disadvantage, it’s not a major downside because you can often refinance your loan if rates fall enough to make doing so worthwhile. While many people think only mortgages can be refinanced, it’s possible to refinance many types of loans including personal loans.
Pros and cons of variable rate loans
There are also some definite advantages to variable rate loans:
- Your starting interest rate will likely be lower: You can almost always get a better initial interest rate with a variable rate loan than a fixed rate loan -- if this isn’t the case, then look for a different lender. In some cases, this rate is locked in for a few months or a few years. If you know you’re going to try to repay your loan early before the introductory low rate expires, it could make a lot of sense to choose the variable rate loan so your interest payments are lower and more of the payments you make will go towards principal.
- Your starting monthly payments will be lower: Since your starting interest rate is lower, your monthly payments also start out lower than a fixed rate loan that has the same repayment term. This can sometimes make it possible to afford a loan that might otherwise be out of reach. If you project your income will increase and higher monthly payments will become affordable later, it can make sense to choose a variable rate loan so you don’t have to wait to qualify for the funding you need.
- Your interest rate could go down: There’s always a chance your interest rate -- and thus monthly payments and total cost of borrowing -- will fall.
You also need to think about the following disadvantages:
- Your payments could rise: If interest rates go up, your monthly payments will go up too. You need to know the maximum monthly payment that you could end up facing with a variable rate loan. If it’s not affordable, you’re taking a huge risk that you won’t be able to pay the loan and could end up defaulting and ruining your credit.
- You may get stuck with the loan: Some borrowers who assume they can pay off the loan early -- or refinance if rates go up too high -- will find that circumstances prevent them from doing so. You may not be able to make the extra payments you planned, or you could lose your job and not have the income to qualify for a refinance loan. This could leave you stuck with a variable rate personal loan that’s very expensive -- and sometimes even too expensive to pay.
- You can’t plan with certainty: Since you won’t know what your monthly payments will end up being for the life of the loan, it’s hard to plan your budget or assess the total costs of borrowing. Make sure you know how often your loan could adjust, because the more frequently it adjusts the greater the uncertainty and the bigger the risk.
Is a variable rate loan right for you?
As you can see, the choice of whether to get a variable or fixed rate personal loan is a difficult one because there are significant pros and cons to each option. You need to think about your risk tolerance, your budget, and what the total cost of the loan could end up being so you can decide which borrowing option is right for you.
In general, though, if you couldn’t afford the maximum payment you could end up owing on a variable rate personal loan, you’re accepting a huge risk that may not be worth taking.
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