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Is a fixed rate or adjustable rate loan better?

Whether a fixed or adjustable rate loan is better depends mostly on the borrower – both are very popular options across a wide variety of loans.

Benefits of Fixed Rate Loans

Clear expectations

A fixed rate loan has a clear payment schedule and amount through the course of the loan – if market rates go up (or down), the payment amount and amount of interest being paid does not change – each payment can be predicted through the course of the loan.

Predictable payments

As a fixed rate loan offers more certainty for the lender, payments are predictable through the timeline of the loan.

Predictable loan timeline

As the total amount being paid is very predictable for the borrower, the end of the loan is also predictable.

Drawbacks of Fixed Rate Loans

Sometimes higher costs

As fixed rate loans give a more predictable payment schedule, they can also mean more risk for lenders – if rates move heavily higher, it can mean a loss for their operations.

More often pre-payment penalties

As lenders typically balance a loan with an investment of the same timeline, fixed rate loans are often more likely to have a pre-payment penalty for paying down a loan sooner than it finishes. While paying off a fixed rate loan earlier may be convenient for the borrower, it means that the lender has other commitments from its savers that it needs to satisfy.

This can change depending on the loan, and pre-payment penalties are an item that is outlined in the loan terms and conditions during the initial negotiation.

 

Benefits of Adjustable Rate Loans

Sometimes lower costs

As adjustable rate loan debt pays interest at the market rate, there is less need to manage risk from rising (or falling) interest rates, meaning lenders may not be seeking a premium for guaranteeing a rate into the future. However, if market situations change and rates increase, then it can mean much more interest rate costs into the future.

Less frequent pre-payment penalties

As adjustable rate loans are less frequently matched with investments for a specific term, they less frequently have pre-payment penalties

This can change depending on the loan, and pre-payment penalties are an item that is outlined in the loan terms and conditions during the initial negotiation.

Drawbacks of Adjustable Rate Loans

Unclear expectations

As adjustable rate loans change with market rates, there is less predictability for the borrower (and the lender) about the interest costs and timeline from the loan.

Unclear payment schedule (or principal repayment schedule)

As rates can change frequently, how longer the loan will take to pay down or the regular payment amount can be unpredictable.

Unclear loan timeline

If market rates shift over the course of the loan (as they normally), the total amount of interest can either increase or decrease over the lifetime of the loan. If interest rates go down and payments stay the same, this means the loan will be done sooner, however if interest rates go up and the payment stays the same, the loan can be done much later.

In other scenarios with the payment amount being paid changing (as frequently happens with credit lines), the payment amount can frequently change on the lender.