When refinancing loans, you can choose between a fixed-rate loan and a variable-rate loan. Both of these work differently. The type of loan you choose will have a considerable impact on how much you pay in interest over the loan term. Neither loan type is the best option for all borrowers looking to refinance their loans. The right option for you depends on several factors. So how do you decide on a fixed or variable rate loan for refinancing? Understanding how each type of loan works can help you decide which one is best for you.
With a fixed-rate loan, the interest rate is set at the time of refinancing. That rate is locked in for the life of the loan. No matter what the prevailing market rates are, this rate doesn’t change at any time. This means the repayment amount also remains the same every month till you clear your debt completely. You don’t have to worry about fluctuations in the interest rate or monthly payments.
The interest rate remains the same throughout the life of the loan. The lenders set the rate based on current market rates and your credit score and other financial credentials. This rate is locked in when you sign the agreement. It won’t change regardless of market conditions. This lowers the risk of a rate hike when markets are stronger.
The monthly payments also remain the same throughout the life of the loan. Your total repayment amount will depend on your interest rate, principal amount, and loan term. This is set at the time of signing the agreement. The total repayment is then spread equally over the term of the loan. This predictability makes it easier to set a long-term budget and to better manage your payments as well as your everyday finances.
At any given time, fixed-rate loans typically have higher interest rates as compared to variable-rate loans. That means you’ll start off paying a higher rate of interest on your fixed-rate loan. And because the rate is locked in, you’ll continue paying the higher rate until you pay off the loan.
You won’t get the benefit of rate drops. Even if markets are weak and interest rates drop, you’ll continue paying the higher rate that was set when you refinanced. You can’t change the interest rate on your loan unless you refinance again.
With a variable rate loan, the interest rate is based on market conditions. When markets are down, interest rates get pushed down too. When markets are high, interest rates increase accordingly. Because market rates are constantly fluctuating, your interest rate could change several times a year. Your monthly payments will also change along with changes in interest rates.
Lower interest rates at the start of the loan. At any given time, variable rate loans have lower interest rates as compared to fixed-rate loans. At the time of signing the loan, you’ll get a lower rate if you opt for a variable rate. This will save you money at the outset.
You’ll benefit if market rates drop. Interest rates are based on the index rate. If the index rate drops, so will the interest rate on your variable rate loan. Even if the rate stays the same through the loan term, you’ll still save more than you would with a fixed-rate loan. This is because of the lower starting rate.
Interest rates are unpredictable. A major downside with variable rate loans is the unpredictability of interest rates. You could pay less on your loan if the rate drops but you may also pay considerably more if index rates increase.
Monthly payments are unpredictable too. Your monthly payments will change every time the interest rate changes. Setting a long-term budget is difficult under these circumstances. A sizeable rate increase could potentially make your monthly payments unaffordable. Ideally, you must make sure to keep the room in your budget for rate increases if you choose this option. However, this may not be possible if you’re earning a low income and your budget is already stretched.
A fixed interest rate loan for refinancing may be the better option for you if:
There are several decisions you’ll have to make when refinancing student loans. Choosing between fixed and variable rate loans is just one of the many decisions that will impact the cost of your loan. To maximize the benefits of refinancing, it’s advisable to explore all your options and weigh the pros and cons of each. Also consider your current financial circumstances, long-term financial goals, and your risk thresholds.
There’s no one decision that’s right for all borrowers. Taking the time to consider all your options will help you make a decision that’s right for you.
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