You’re thinking of taking out a loan to finance your need - great move!
But, before you complete your loan application, you’ll need to decide between a variable rate loan or a fixed-rate loan.
Choosing between a variable-rate loan and the fixed-rate loan is no easy feat.
Each type of loan has its pros and cons, and what is right for you may not necessarily be the best option for other borrowers.
So which type of interest rate loan should you get?
Answer: The right one depends on your budget, how long are you planning to pay for the loan and the tolerance for risk when the interest rate changes.
If you’re comfortable with the market telling you the interest rate of your loan - variable rate loan may be the way to go.
What is Variable-rate Loan
In a variable or floating rate loan, the interest rate may increase or decrease throughout the duration of the loan.
This kind of loan is known to be the riskier choice due to the fluctuating interest rates that can significantly affect the cost of borrowing. The interest rate, however, may start at a much lower rate and will rise or fall depending on the changes in the money market.
Due to the possibility of an increased interest rate, you could end up paying more each month. However, a variable rate loan can be advantageous to those with a shorter loan tenure.
With a shorter repayment period, you can greatly benefit from the lower interest rates. You don't have to worry about the increasing interest rates during the latter part of your repayment period because you were able to save on lower interest rates early on.
Keep in mind that a variable interest rate is not an option for everybody. While it could help you save on interest rate on a short-term loan, you still have to think about the risk of your loan increases over time.
If you’re willing and able to take on some risk, a variable-rate loan is a great option.
How does variable rate loan work
The variable rate is tied to the Manila Reference Rate (MRR), Treasury Bill Rate (TBR) and other market-based reference rates.
These benchmarks calculate the interest rate based on the weighted average of the interest rates paid during the previous month by a ten (10) commercial bank with the highest combined savings and fixed deposit.
Such rates will be reviewed and determined at the start of every calendar semester based on the bank’s combined amount of cash and time deposits.
Simply put, the interest rate is determined and calculated based on the lending rate set by the Central Bank of the Philippines.
The bank then considers the state of the economy when determining the rate.
In some cases, the rates determined by the bank gets exceptionally high since there is no limit on how much the interest rate in a year.
To counter this, banks offer a ceiling on variable rate loans to help protect borrowers when the interest rate becomes exceedingly.
However, the caps are often set at a high level - so it doesn’t do much in protecting against the unpredictability of the market. When this happens, the fixed-rate loan is your best guarantee to long-term affordability with its low interest rates.
Alternatively, if you prefer a loan that’s easy on your budget and pay the exact loan amount consistently, a fixed-rate loan may be the better choice.
What is Fixed Rate Loan
A fixed-rate loan is a type of loan where the interest rate stays the same for the entire loan period. This means that you will be charged the same amount of interest each month and the money market, no matter how much it fluctuates, cannot influence the cost of borrowing money
The fact that the interest rate does not change is one of the strong points of a fixed-rate loan as it allows you to plan and budget for your payments. It also works like an “interest rate insurance” which is helpful for potential borrowers with tight budgets.
The fixed interest protects the borrowers from any surprising increases in the cost of their loan due to the possibility of rising interest rates.
So, you don’t have to worry about the interest rate going high because your repayments will not be affected and you can easily set an accurate budget for your loan every month.
- The interest rate of a fixed-rate loan stays the same throughout the loan period.
- In a variable-rate loan, the interest rate fluctuates all throughout the life of the loan.
- The interest rate of a variable-rate loan is determined by different factors set by the Central Bank of the Philippines.
- When the interest rate set by the bank gets too high, variable-rate loans have a ceiling interest rate.
If you're unsure which loan to get, the Bear has broken down the upsides and downsides of each type to help you make a more informed decision.
The Pros and Cons Variable-rate Loan vs Fixed-Rate Loan
When comparing fixed-rate loans and variable-rate loan, you’re choosing between certainty and flexibility. The idea of a lower interest rate can be tempting, but the stability of paying for the same interest rate feels secure.
If you’re having a hard time determining which one is for you, here are the advantages and disadvantages of each loan.
A fixed-rate loan is easy on your budget with the protection of having the same interest rate. The interest rate is low and stable but generally higher compared to a variable rate loan.
On the other hand, the interest rates on a variable-rate loan start low. This can help you save money, especially when the rate remains stable or fall during the life of your loan. But, be prepared for the potential increase of your loan since it’s a variable-rate loan.
Variable-rate loans usually provide options and flexibility. This means you can pay more than the minimum required amount when the interest rate is low, shorten your loan term or switch to another lender without facing any penalty fees.
Fixed-rate loans, on the other hand, do not offer flexibility on repayment terms. While you pay for the exact loan amount, you may be hit with penalty fees when you decide to pay early or more than the minimum.
Another drawback of a fixed-rate loan is that you may be charged with breakage fee when you decide to switch banks or switch to a variable-rate loan with your existing bank.
If you choose a fixed-rate loan, be sure to stick to the rate and repayment on the agreed period.
A variable-rate loan is an excellent option for short-term loans. If you choose variable-rate for a long-term loan, you may be putting yourself in a financial mess.
Choosing a long-term loan means you could be paying more than what you owe since rate changes can be challenging to predict, and a lot can happen over the life of your loan.
If you’re looking into a fixed-rate loan, it’s ideally suitable for long-term repayment. The certainty of having the same interest rates for the rest of the loan period protects you from the unpredictability of the market.
Choosing Between a Fixed and Variable Rate Loan
Let’s assume that you meet the requirements and have a good enough credit score to qualify for both loans.
You’ll need to decide which is more important to you: certainty or flexibility?
If you want certainty, get a fixed-rate loan. You’ll get a straightforward amount of how much you will have to pay monthly which is suitable for a long-term repand there’s nothing you need to worry about when the market changes. Super simple.
Now if you want to maximize the flexibility of a variable-rate loan, get it. If the rate of interest in the market is low, you can take advantage of the flexibility and pay more than the minimum to maximize the loan amount you borrowed on a short period.
The interest rate is lower than a fixed-rate loan, but it can get higher when the market fluctuates. So, make sure you can take the risk and tolerate it when the interest in the market changes.
Before you decide, use a comparison tool!
Taking out a loan can be stressful and nerve-wracking. Choosing between a variable-rate loan or fixed-rate loan is one of the critical decisions you’ll make. It’s essential to have all of the information available before committing.
If you prefer to sit back and have a fixed budget for your loan, you can choose a fixed-rate loan. If you want flexible payment options and don’t mind the unpredictability of the market, go for a variable-rate loan.
The choice of your loan should depend on your situation, financial goals, and priorities. You need to take into account your cash flow and the need for security and flexibility whichever loan you choose.
If you found this post helpful, you can start looking for the best personal loan that suits your needs.
Make sure to compare interest rates on each loan to save time and find the best-priced option available in the market today.