When taking out a loan, it pays to weigh the pros and cons of a variable interest rate.
Most important points:
- Variable interest rates make sense in specific situations, such as when you plan to buy and sell a home in a few years’ time or pay off a loan early.
- However, floating rate loans can be risky because interest rates can rise.
- Fixed-rate loans are almost always more reliable and easier to budget.
When it comes to borrowing money, one of the decisions you have to make is whether to loan with variable or fixed interest. A floating rate is an interest rate that goes up and down over time. Because variable rates are tied to an underlying benchmark rate, they mimic what happens to that underlying rate. For example, the variable interest rate rises when the benchmark interest rate rises.
While fixed-rate loans are more common, you may be surprised to learn that a variable-rate loan works best for you in certain situations. Here are four.
1. You don’t expect to hold a loan for long
Let’s say you’re moving to a new city, but know that you’ll only be there for two or three years. You buy a home and notice that the variable interest rate is lower than the fixed interest rate. The less time you wear variable rate mortgage, the less likely the underlying benchmark will rise and your floating rate rise. So it can make sense to go for a variable interest rate if you know that you will not hold the loan for long.
Another example is if you expect money from an annuity, life insurance policy or work bonus. If you borrow money in the months leading up to that big payday (and plan to pay off the loan with the money), a variable interest rate can save you money because of the lower interest rate.
2. You think interest rates are going to fall
Like the weather, interest rates can change day by day. If you borrow money and all indications point to a declining interest rate, taking out a variable-rate loan can also reduce your monthly payments. That said, if you’re wrong and interest rates go up, you’ll see your payments go up.
3. You use the monthly savings to pay off the principal
Imagine that you have a debt consolidation loan for $50,000. The fixed rate is 6% and the variable rate starts at 4%. The term of the loan is 10 years. By adopting the variable rate, you will save about $50. If you plan to use it monthly savings To pay off the principal (the original amount you borrow), you not only pay off the loan early, but you also save more than $1,200 in interest.
The fly in the ointment is that this plan only works if the floating rate doesn’t rise before the loan is paid off. The longer you have a variable interest rate, the greater the chance that interest rates will rise.
4. Entering into a variable interest rate is the only way to qualify for the loan
If you are making a major purchase, such as buying a house or plot of land, and you are not eligible for a fixed rate mortgageyou may be eligible for a variable loan with a lower interest rate and monthly payment.
However, if there is a slightly higher interest rate between you and a loan, you may want to reconsider the purchase — at least for now. The fact that you are not eligible for the fixed rate loan indicates that you may be taking on a greater obligation than you can easily afford.
The bottom line is this: A variable rate loan usually only makes sense in specific situations. With a fixed rate loan, you can budget in the knowledge that your loan payments will not increase over time. If you can get a sufficiently low interest rate on a fixed rate loanit is almost always the more reliable choice.
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