When you need to take out a loan, whether it’s a home loan, car loan or personal loan, you have a choice between fixed-rate and variable-rate terms. Both fixed and variable interest rates can be beneficial depending on many factors, including your current financial situation, your comfort level with fluctuating rates and your credit score. Learn more about your two options so you can make an informed decision.
Definitions
Fixed Interest Rates:
“An interest rate that will remain at a predetermined rate for the entire term of the loan, no matter what market interest rates do. This will result in payments remaining the same over the entire term.”
Variable Interest Rate:
“An interest rate that moves up and down based on the changes of an underlying interest rate index.”
How Fixed and Variable Rates Work
Fixed-rate loans
Fixed-rate loans feature a set interest rate for the entire term of the loan. A fixed-rate loan is a great option for those who:
- Prefer consistent monthly payments
- Plan to pay the loan over a longer term
- Follow a personal budget and enjoy the predictability that a fixed rate allows
- Qualify for a low interest rate and want to secure it for their entire loan term
- Expect interest rates to increase, and want to lock in a lower interest rate now
When someone applies for a loan with a fixed interest rate, the rate they will receive is typically determined at the time of approval, and it does not change for the entire life of the loan. When lenders determine price points for their fixed interest rate products, they base them on market rates available at that point in time.
Lenders who offer credit-based pricing will offer a range of rates on their fixed rate product, based on creditworthiness. In that case, the better the applicant’s credit score is (or that of the cosigner/co-applicant), the better their chances for a lower rate.
The market rate, on the other hand, depends largely on the length of the loan and other features, and can vary based on market conditions. This means that lenders may change the fixed rates they offer to new applicants as market conditions change – consumers should review the lender’s current product offer before applying for a loan.
Variable Interest Rates
Unlike fixed-rate loans, variable-rate loans (sometimes called adjustable-rate loans) do not offer borrowers one steady interest rate over the life of the loan. The fluctuations of the interest rate are based on current market conditions and, in the case of CIBC loans, on the CIBC Prime lending rate.
Variable-rate loans are good for those who:
- Plan to keep the loan for only a short period of time
- Are confident that lower interest rates will become available down the road
Comparing Fixed and Variable
Generally, a fixed interest rate will be higher than the corresponding variable interest rate in a rising interest rate environment. Borrowers sometimes get confused about the difference in the current interest rates, picking the variable-rate loan because the current interest rate is lower. In effect, they treat the variable interest rate as though it were a fixed interest rate. But, lenders price fixed and variable-rate loans to yield the same income to the lender, based on models that predict a range of future changes in interest rates.
Assuming a rising interest rate environment, a fixed interest rate on a new loan with a 10-year repayment term will generally be 3 or 4 percentage points higher than the current variable interest rate.
There are two scenarios in which a variable interest rate is better than a fixed interest rate.
- If interest rates are decreasing, the cost of a variable-rate loan will decrease, leading to lower monthly loan payments.
- If interest rates are likely to increase and the borrower plans on paying off the debt before interest rates rise too much, a variable interest rate can save the borrower money. In a rising interest-rate environment, variable interest rates start off lower than fixed rates. By paying off the loan before the variable interest rates reach the fixed rate, the borrower will have a much lower average interest rate.
If interest rates are rising and are expected to continue rising, it may be best for a borrower with a variable-rate loan to refinance the loan into a fixed-rate loan before the interest rates start rising