Personal loans are in vogue for a million reasons, especially for being the best option to meet any financial emergencies. You can use this open-ended loan for pretty much anything, but it is very important to consider the conditions and risks that might come along. Not stopping here, personal loans might also be available in different options, like fixed interest rates or variable rates. In this blog, we will uncover the key points of difference between fixed-rate loans vs variable-rate loans.
What is a Fixed Rate Loan?
Personal loans that are offered at a fixed interest rate are known as Fixed-rate loans. Since the rate of interest remains constant throughout the repayment tenure, there will be fixed EMIs for every month. With this, it is easy to evaluate which loan amount suits you best on the basis of your income. Hence, this type of interest rate is ideal for personal loans with a longer repayment tenure.
If interest rates are relatively low in the market at the present day but are about to increase, then it will be better to lock in your loan at that fixed rate. Depending on the terms and conditions of your loan sanctioned, your interest rate on the new loan will stay the same, even if interest rates climb to higher levels.
What is a Variable rate loan?
A variable interest rate on a loan makes it a variable rate loan or floating interest rate loan. The interest rate charged on the outstanding balance varies according to the change in market interest rates. Thus, the interest charged on such a loan depends on an underlying benchmark or index, for example, the federal funds rate. You can find variable interest rates in mortgages, credit cards, personal loans, derivatives, and corporate bonds.
Since the interest rate is subject to periodic revisions as per the rate changes according to a lending benchmark set by the RBI, lenders determine a base margin or repo rate. Any change in this repo rate results in a change in the interest rate applicable to loans and advances extended to borrowers.
Although the EMIs for variable-rate loans may remain unchanged, interest rate adjustments are reflected in the loan tenure due to an increase in the total repayment liability.
Pros and Cons of Fixed Interest Rate
| Pros | Cons |
| Interest rates remain fixed throughout the loan tenure, making monthly EMIs predictable. | Fixed interest rates are often higher than initial variable rates. |
| Ease in budgeting due to consistent monthly payments. | This type of loan is not flexible. If interest rates decline in future, you simply miss out on potential savings. |
| It safeguards against the rising interest rates. | In the case of early repayment, change in terms or exiting the loan, fixed-term fees may incur additional charges. |
| Borrowers can self-select their loan tenures for many loans, ranging from 6-month to 10-year non-mortgage loans. | Generally, it is more expensive over their life than variable rates. |
Pros and Cons of Variable Interest Rate
| Pros | Cons |
| Floating-rate loans offer a lower initial interest rate compared to fixed-rate loans. This can lead to lower initial EMIs. | If the interest rates rise., the initial low-rate advantage might not last long. |
| There is a good chance of having a lower overall cost of the loan if the interest rates remain stable or decrease. | If interest rates increase significantly, the EMIs can rise, making the loan more expensive. |
| The fluctuating interest rates can help pay off loans faster, especially when the loan rates decrease. | Rising EMIs can strain the budget and might exceed borrower’s repayment capacity. |
| The interest rate for a variable loan is generally lower than a fixed loan. | It is difficult to plan or forecast future cash flow due to changing rates. |
Fixed Rate vs Variable Rate: Which is Better?
In the scenario of decreasing interest rates, a variable-rate loan is better. However, the deal breaker is that there’s a risk of higher interest rates as per the market conditions in future.
On the contrary, if the primary objective of a borrower is to take less risk, a fixed-rate loan is better. Although the debt may be more expensive, the borrower will be able to access their repayment schedule and cost. Let us throw more light on this subject:
IDEAL CIRCUMSTANCES TO OPT FOR A FIXED-RATE LOAN:
- When the borrowers want to maintain their total repayment liability and EMIs throughout the loan tenure and move forward in a predictive way.
- When no changes in the repayment tenure are needed.
- Not ready to take risks with the changing market rates.
- When looking for precise financial planning.
IDEAL CIRCUMSTANCES TO OPT FOR A VARIABLE RATE LOAN:
- When the borrowers are well aware of the trend of repo rate cuts. This way, repayment liability is kept in check due to a reduction in interest rates.
- When borrowers are ready to take a risk in order to increase their savings.
- When there is a chance of pre-payment or early payment of the loan liability, this can help save significantly on both the total repayment amount and pre-payment fees.
There is a constant tug-of-war between fixed-rate loans vs variable-rate loans, and the answer to it is not constant. Choosing the best option between fixed and floating interest rates depends on your suitability when applying for a loan.
Things to Remember When Refinancing Your Personal Loan
Which one should you choose, fixed interest vs variable interest? The answer to this must now be clear to you. But there are several other factors to consider while deciding on the type of rate to pursue:
1. Check the market trends:
You need to have all the updates on interest rates going up or falling. If your analysis reveals that the interest rates might go up, then it is wise to go for a fixed-rate agreement. If you believe that there are chances of interest rates falling or remaining stable, then it is ideal to go for a variable-rate agreement for the short term.
2. Know the interest rate spread:
Sometimes, one loan might seem more expensive than the other, but it might have better flexibility than the other. In that case, compare the terms of both the fixed rate and variable rate loans thoroughly. Carefully spot the differences between the terms for a fixed loan versus a variable loan before finalising.
3. Loan term:
It is difficult to predict the economic conditions in the long term; thus, decide on the basis of short-term conditions. If you do not wish to collect a lot of debt for a longer period, the best thing to do is to choose a loan type that offers flexible repayment tenure. Also, consider your long-term expenses, such as buying a home, car, etc.
4. Personal income financial forecast:
The decision to choose fixed vs variable-rate loans depends a lot on your income situation, including job stability, prospective salary growth, and current savings. If you can generate higher income in the future, the risk of variable rates decreases as you can have more disposable income to counter rising expenses.
Conclusion
There is no one type that fits all types of interest rate. No single type of interest rate works best for everyone. Some borrowers prefer having a variable interest rate that can give potential savings due to a drop in the rate in the future. Others might prefer knowing their fixed interest rate to establish a consistent amortisation schedule of payments. Think carefully of the risks and downsides – whether to choose a fixed rate loan or a variable interest rate loan.
Frequently Asked Questions:
What is an example of a variable interest rate?
The best examples of variable-rate interest loans are Adjustable-Rate Mortgages (ARMs), credit cards and personal loans. ARMs initially offer a fixed interest rate but later adjust based on market indexes, while credit cards commonly have variable interest rates that can fluctuate. And there are personal loans that also offer variable interest rates influenced by inflation or government policies.
What is an example of a fixed interest rate?
A fixed deposit or FD is a type of fixed-rate investment where the interest rate remains the same for the duration of the deposit. Many banks also offer compound interest on fixed deposits, which means that interest can be earned on both the principal and the interest.
What are the advantages of a Variable Rate?
Variable-rate loans have their own set of advantages. They can be beneficial during periods of decreasing interest rates, which results in low monthly payments and reduced overall interest costs.
Can a Fixed Rate change during the loan term?
No, a fixed-rate loan maintains the same pre-decided interest rate throughout the entire loan term. This means your monthly payments will remain the same.
Is a Fixed-Rate Loan always more expensive?
A fixed-rate loan offers stability by fixing the interest rate. They assure that even if interest rates are expected to rise in the future, a fixed-rate loan can be a cost-effective choice. It is the best choice if your risk tolerance is zero, and thus they are expensive.
Is it possible to switch from a Variable Rate to a Fixed Rate (or vice versa)?
Yes, it is mostly possible to switch between variable and fixed interest rates for certain financial products. You may also choose to refinance a personal loan. Additionally, some credit card providers offer the option to switch between variable and fixed interest rates for specific balances. However, the feasibility of this switch depends on the policies and current market conditions.