When considering loans, there are two main types of interest rates: fixed rates and variable rates. Fixed rates provide a stable interest rate throughout the loan term, offering the borrower certainty about the amount they will pay over time. On the other hand, variable rates fluctuate with the interest rate market, leading to potential changes in the borrower’s payments depending on how interest rates move.
Certain loan products, like lines of credit, exclusively offer variable rates due to their nature. Since lines of credit have no specific term, banks cannot guarantee a rate indefinitely, which makes variable rates more suitable for such arrangements. Although fixed term revolving products like lines of credit could be introduced to make fixed rates more popular, variable rates currently dominate the market due to public acceptance and demand.
Credit cards generally come with a fixed rate, but these rates can be subject to change at the lender’s discretion. Typically, credit card interest rates are set relatively high compared to other loan products, and while they may occasionally increase, changes are infrequent.
It is crucial to be aware that even fixed rates may be subject to conditions. For instance, if you fail to fulfill your payment obligations as agreed, the lender may increase your rate until they are more confident in your repayment ability. This highlights how risk factors into interest rates and the importance of being prepared for potential rate adjustments when carrying a balance.
In contrast, variable rates are constantly subject to change, depending on the lender’s interest rate benchmark. Typically, your rate will be fixed against the lender’s prime rate or another benchmark they use. Changes in central bank rates influence the rates that banks and other lenders charge, leading to adjustments in variable rate loans, including both existing loans and new ones.
For loans with a spread of the bank’s prime rate plus a fixed percentage (e.g., 2%), the spread remains constant unless the terms are renegotiated. In this case, the prime rate becomes the variable part that determines changes in the interest rate. This is why central bank rates, like those set by the Federal Reserve, are closely monitored, as they impact not only banks borrowing from them but also existing variable rate loans and new loans taken after the rate change.
Although spreads on variable rate loans can change occasionally at the lender’s discretion, these adjustments are relatively infrequent. As borrowers, it is essential to stay informed about the possibility of rate changes and make financial decisions accordingly.
Rates Depend Both On our Risk and Interest Rate Market Risk
Interest rates play a crucial role in loans, considering both individual risk and interest rate expectations. Whether it’s a fixed or variable rate, these factors are carefully evaluated. Individual risk is assessed by lenders, establishing a base risk that serves as the foundation for fixed rates or expressed as the spread for variable rates. The spread on variable rate loans can change based on market outlook, often adjusting when variable rates drop too low, prompting lenders to increase the spread to extract a higher premium over the benchmark rate.
In fixed rate loans, the future outlook for interest rates is factored in, and lenders take on the additional risk for a price. Borrowers may be presented with a choice between a fixed rate and a variable rate, with the fixed rate compensating the lender for the risk of rates rising beyond projections, along with a risk premium component.
As interest rates fluctuate, the advantages of fixed and variable rates vary. When rates increase, fixed rate loans become relatively cheaper compared to variable rates. Conversely, when rates decrease, fixed rates become more expensive while variable rates become more affordable. However, accurately predicting future interest rate movements is challenging, and though educated guesses are usually made, there’s always a chance of being wrong.
Setting rates to break-even is insufficient for lenders, as they must be incentivized to take on risk. Therefore, an additional amount is added to fixed rates to make it worthwhile for lenders to shoulder this risk rather than assigning it to borrowers through variable rates.
While fixed rates may cost more over time, they can still be advantageous depending on how the interest rate market evolves during the loan term. However, fixed rates ultimately benefit lenders, as they need the added benefit to engage in this type of lending.
Some may view the decision between fixed and variable rates as an equal expected value proposition, but it’s essential to recognize that it’s not merely a matter of gambling with rates or hedging bets. In many instances, borrowers will end up at a disadvantage, facing significant differences in outcomes.
Fixed Rates Have a Lower Expected Value Overall
Opting for fixed rates is akin to buying peace of mind, similar to the way we seek security through insurance. While the price difference between fixed and variable rates may not be substantial, even a small percentage point on a loan can lead to significant costs over time.
When fixed and variable rates are closely aligned, it suggests an expectation of decreasing interest rates. Sometimes, fixed rates may even be lower than variable rates because lenders anticipate a near-term decline in variable rates.
Lenders’ decisions on interest rates are based on thorough analysis, far beyond what the average borrower can comprehend. Looking at the spread between fixed and variable rates can provide insight into lenders’ expectations of interest rate movements, but attempting to outsmart banks in this regard is impractical and unrealistic.
Lenders set their rates with diligence and precision due to the enormous financial stakes involved. Assuming we can out-speculate banks on interest rates without relevant expertise or special powers is unwise.
Instead, a more sensible approach is to recognize that banks have likely priced their fixed rates advantageously. We can then weigh the extra cost of fixed rates and decide whether the peace of mind it offers justifies the expense. Psychological factors often influence borrowers to choose higher-cost fixed rates, even if they are unaware of the difference in cost or believe that the choices have comparable expected values.
Variable Rates Are Preferable Unless We Really Do Need to Fix Rates
The psychological benefit of choosing fixed rates often stems from a lack of proper understanding of the two options and an inclination to be overly risk-averse. If the fluctuations in interest rates do not materially impact our ability to repay the loan or meet other financial needs, there might not be a significant risk to consider. In such cases, opting for variable loans without paying extra for unnecessary hedging might be more appropriate.
However, it is crucial to assess our specific financial situation to determine if the potential risks are significant. If our financial circumstances are tight and we can only afford the payments at the fixed rate without facing hardship, then considering the risk of variable rates becomes relevant.
Some lenders offer the option to switch from a variable rate to a fixed rate if the borrower becomes uncomfortable with the fluctuations. While this option may influence a borrower’s willingness to accept risk, it’s essential to understand that any changes in interest rates that caused fixed rates to rise will likely be factored into the fixed rate at the time of switching.
Viewing the option to switch as an escape hatch can be misleading, as it may not provide the expected benefits. Switching to a fixed rate later may come with a higher cost and may not shield us from previously incurred risk.
Ultimately, the decision to choose fixed or variable rates initially or switch between them later should be based on our individual circumstances, not on trying to speculate on the interest rate market. Borrowers typically lack the expertise and resources to effectively speculate in this market, which is primarily utilized by large institutions for hedging and speculation purposes.
While some borrowers may prioritize peace of mind over expected value and be willing to pay more to avoid worries, it’s crucial to recognize the additional cost and assess whether the perceived benefits align with our financial goals.
