If you want to start a new business or expand your existing business into new products and markets, you need a solid approach to financing. There are several other options for securing funds.
Lenders offer many types of loans, the two most popular being fixed-rate loans and variable-rate loans. I’ll explain the difference between the two, so decide which one is right for you.
What is a variable rate loan?
Variable rate loans are not loans or credit loans in the same sense that mortgage loans, student loans, credit cards or car loans are. They are certain types of loans designed for certain purposes. “Variable interest” simply describes how interest accrues on the balance of the loan.
If a loan, such as a mortgage, car loan, or personal loan, has a variable interest rate, it means that the interest rate on the loan can change over time. The same amount is not fixed over the life of the loan.
When you apply for a loan, you often have a choice between a fixed or variable interest rate. If you choose a variable interest rate, the loan disclosure should clearly state how and when the interest rate will fluctuate.
Here’s how variable-rate loans work.
Variable interest rate loans are tied to a specific reference interest rate or benchmark index, such as the London Interbank Offered Rate (LIBOR). LIBOR is the interest rate at which banks lend to each other. The interest rate is determined by asking the bank and getting information about the interest rate you pay when you borrow from a similar institution.
An alternative to LIBOR is preferential rates in one country. Prime interest rates are used as the base interest rates for auto loans, home equity loans, and credit cards. This interest rate is tied to the Federal Reserve Fund rate, which is the rate charged on the daily loans to meet reserve funding requirements. Federal interest rates are governed directly by Federal Reserve policy.
LIBOR and the nation’s prime interest rate are used by commercial lenders as a starting point for setting interest rates. Generally, borrowers charge consumers a spread or margin on a selected benchmark interest rate to generate income. The markup imposed on the consumer depends on various factors: the term of the loan, the type of asset, and the level of risk to the consumer (credit rating).
The benchmark and the lender’s margin/spread are combined to calculate the actual interest rate charged to the consumer. For example, a car loan might be priced at 6 months at LIBOR + 3%. This means that the loan uses LIBOR as the base interest rate and fluctuates every six months. 3% is the margin that banks charge consumers.
How do you choose?
What is the best choice for you? There is no universal right or wrong answer. Decisions about loan amount, term, fixed or variable rate depend on your personal circumstances and flexibility.
If you want to know exactly how much your monthly payments will be over time, you may prefer a fixed-rate loan. Also, if you plan to repay your loan over a longer period of time, such as 10 or 20 years, you may prefer to choose a fixed-rate loan to eliminate the risk that your interest rate will fluctuate over time.
Conversely, if you want to take advantage of maximum savings but have the financial flexibility to pay more each month if your interest rate increases, you may prefer variable interest rates. You may also prefer variable-rate loans because you plan to repay the loan over a short period of time, such as 10 years.
Because variable-rate loans depend on current market rates, the total amount of interest you owe is subject to changes in the broader environment.
Type of Variable Rate Loan.
The types of loans that can be made at variable rates are very varied.
Credit cards provide borrowers with an easy way to borrow money in a short period of time without having to apply for a new loan. But they are notorious for their high interest rates.
Most credit card agreements state that the interest rate on the card balance can vary and can be adjusted without notice.
Personal loans can be offered at fixed or variable rates. It is up to the borrower to choose what to offer, and you can choose which type of loan to apply for. Generally, variable-rate loans have a lower initial rate than fixed-rate loans.
When you get a credit limit, such as a personal loan limit or a mortgage limit, variable rates usually apply.
Student loans can have fixed or variable interest rates. While government loans usually have a fixed rate, private borrowers can choose whether to offer a fixed or variable rate on their loans.
Home Equity Loan.
If you get a mortgage, you can apply for a fixed-rate mortgage or a variable-rate mortgage (usually known as a variable-rate mortgage). Variable-rate mortgages usually adjust annually based on the underlying interest rate, while keeping the interest rate fixed for five to 10 years.
That’s the advantage of variable-rate loans.
For borrowers, variable-rate loans are often subject to lower interest rates than fixed-rate loans. In most cases, interest rates tend to be lower initially and can be adjusted over the life of the loan. However, during periods when interest rates are constantly fluctuating, fixed-rate loans tend to be more attractive than variable-rate loans. In this case, a fixed-rate loan comes with an interest rate that does not change over the life of the loan.
From the borrower’s perspective, variable-rate loans offer more value than fixed-rate loans. Borrowers can adjust the interest rate upward to reflect changes in the market, and the interest charged on a fixed r