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When it comes to loans and bank accounts, interest rates matter. Savings account interest rates dictate how much your deposits earn. Loan interest rates, on the other hand, determine how much it costs you to borrow money.
These interest rates can be either fixed or variable, impacting your cost or earnings over time. In some cases, fixed interest rates are advantageous; in other circumstances, you may be better off with a variable-rate account.
Learn more about the difference between fixed vs. variable rates and how each can affect your finances.
What is a fixed interest rate?
A fixed rate doesn’t change; it’s locked in for the duration of your loan or term. No matter what happens to benchmark rates during that time, your rate will stay the same. Both borrowers and savers can benefit from fixed rates in certain circumstances.
Certificates of deposit (CDs) are an example of an account that earns fixed interest. In exchange for that fixed interest rate, you must agree to leave your funds on deposit through the duration of your CD term.
Many bonds also earn fixed interest. Bonds are an investment in which you loan money for a set period of time in exchange for a fixed amount of interest paid out at maturity.
Certain loans have fixed interest rates too. For example, more than 90% of mortgages in the U.S. have fixed rates, providing borrowers with predictable monthly payments throughout the life of the loan. Personal loans, home equity loans, auto loans, and federal student loans also commonly have fixed interest rates.
Pros and cons of fixed rates
While fixed interest can be an advantage in some cases, there are disadvantages to consider too.
Pros
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Fixed rates simplify budgeting. With a fixed-rate loan, you know exactly how much you’ll owe each month because your payment won’t change. It’s easier to budget around a fixed payment than one that changes each month.
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You can lock in a better rate. Depending on the current interest rate environment, a fixed-rate loan or account can work in your favor as rates change in the future. For example, locking in a fixed-rate loan in a rising-rate environment can save you money over time because you won’t pay more in interest as rates rise. Similarly, opening a CD when rates are dropping means you can take advantage of higher earnings even after benchmark rates go down.
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You can enjoy more financial stability. Fixed rates, whether you’re borrowing, saving, or investing, can provide an overall sense of financial security. As a borrower, you know exactly how much you owe, and as a saver, you can count on fixed earnings. This can make it easier to make informed financial decisions and plan for the future.
Cons
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You may sacrifice the best rates. Sometimes, choosing a fixed-rate loan means you won’t get the best rate up front. For example, adjustable-rate mortgages may offer a lower initial rate compared to fixed-rate mortgages.
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You may miss out on better rates in the future. Locking in a rate in a changing interest rate environment can be risky. If rates improve in the future — meaning loan rates drop or savings rates rise — you’ll miss out on lower costs or higher earnings.
What is a variable interest rate?
Variable rates change over time, often in response to benchmark interest rates. This means that as a borrower, your payments can change month to month, and as a saver, your earnings are unpredictable. Like fixed rates, variable rates can be advantageous, but it depends on the context.
Common examples of accounts with variable interest rates include savings accounts, interest-bearing checking accounts, and money market accounts. All of these accounts pay you interest on your deposits, but that interest rate can change at any time.
Certain loans and debt products can also have variable interest rates, including adjustable-rate mortgages, home equity lines of credit (HELOCs), credit cards, personal loans, and private student loans.
Read more: How do banks set their savings account interest rates?
Pros and cons of variable rates
Like fixed interest rates, there are pros and cons to accounts and loans with variable interest rates.
Pros
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You may get lower payments up front. Sometimes, variable-rate accounts may offer better rates up front. For example, adjustable-rate mortgages may offer lower rates for the first few years of the loan, which can be beneficial if you don’t plan on being in your house for long.
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Changing rates can be advantageous. Sometimes, rates can change in your favor. For instance, having a variable-rate savings account in a rising interest rate environment means you’ll earn more as rates rise. Similarly, variable interest rates can be advantageous for borrowers when benchmark rates fall.
Cons
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Savings rates may drop, and borrowing costs may rise. While variable rates can change in your favor, the opposite can also be true. Depending on the circumstances, you may end up with lower savings rates or higher borrowing rates in the future.
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Variable rates make it harder to budget for loan payments. With changing rates and monthly payments, you won’t be able to plan on a consistent expense. Instead, you’ll have to constantly budget around a changing monthly payment.
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Variable rates can come with more risk. As with any unknown, there’s risk involved in choosing a variable-rate product. If you’re risk averse, you may be less comfortable with variable-rate loans or accounts.
Read more: Fixed vs. variable expenses: Key differences and how to budget for each
Which is better: A fixed or variable interest rate?
Whether a fixed or variable interest rate is better for you depends on your circumstances and preferences. And like many financial decisions, there isn’t one right answer.
Here are some factors to consider when choosing between a fixed-rate vs. variable-rate product.
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Your timeline: Sometimes, a short timeline can make variable interest rates more attractive. One example is buying a house that you intend to sell relatively soon. In this case, you may benefit from a variable-rate mortgage, which can come with lower up-front rates compared to fixed-rate loans.
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The current rate environment: If interest rates seem to be heading a certain way, pay attention. You may want to choose a variable-rate account if you expect rates to move in your favor.
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Your risk tolerance and flexibility: Variable rates come with more uncertainty and risk compared to fixed rates. If you have a low risk tolerance and less flexibility in your budget or savings goals, a fixed-rate account may be a better fit. But if you’re okay with a little uncertainty, a variable rate might be appealing.
Regardless of what you choose, make sure you understand how fixed and variable interest rates work and how these interest rates can impact your finances in the future.
