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Finance is a complicated topic. Registered investment advisors (RIAs) go to school for years and then take a series of exams before they can become registered. Certified financial planners (CFPs) do complex math on spreadsheets while the rest of us figure out how to use a loan payment calculator. They’re professionals. Most consumers aren’t on the same level.
Thankfully, there are some finance topics that are easy to explain, like fixed and variable interest rates. Most adults have paid both at some point in their lives and may not realize it.
Credit card companies charge variable interest and most personal loans and mortgages do not. In this article, we’ll explain what the difference is and how it affects the consumer.
A fixed interest rate is a rate that is set at the inception of a loan and doesn’t change during the repayment term. Let’s say the loan is for $5,000 at a 10% fixed rate for five years. Repayment for that loan is made in sixty equal monthly installment payments. Amounts for those payments are fixed at the beginning because the interest rate remains constant.
The same concept can be applied to mortgages, but the repayment term is typically much longer than with a personal loan. Most mortgages are fifteen, twenty, or thirty years. Fixed interest is calculated annually and added to the monthly payment, along with any fees or charges from the lender. This combination is known as the annual percentage rate or APR.
Fixed interest rates are good for the borrower if rates are expected to rise. During the 2020 pandemic and the following months, interest rates were near zero. Anyone who bought a house during that time is now paying significantly less than what buyers are paying now. The Federal Reserve Bank has been steadily raising interest rates in 2022.
Credit card companies charge a variable rate of interest on outstanding balances owed. That’s a good reason to pay off those balances in full every month. If the prime interest rate is high, the credit card interest payment will be increased. The terms and conditions of the credit card contract should clearly state how they calculate it each month.
Lenders and mortgage companies also offer variable interest rates, which may not be good for the consumer. Adjustable-rate mortgages (ARMs) were primarily responsible for the financial crash of 2008. They’re attractive because the rate is lower at the beginning of the term. Problems arise when interest rates increase, and the monthly payments increase.
Having a fixed rate of interest and monthly installment payments that don’t change makes budgeting simpler. Variable interest rates can be like playing the lottery. There are wins, and there are losses. That’s okay for a short-term personal loan. It’s risky when taking out a thirty-year mortgage. Fixed-rate mortgages are safer and far more popular.
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