What is the danger of getting a variable interest rate loan?

What is the danger of getting variable interest rate loans? When you get a variable interest rate loan, the loan’s interest will change over time. The lender changes the interest rate in response to market rates. If market rates increase, the interest you pay on the loan will go higher. On the other hand, if market rates decrease, the lender will lower your interest rate to reflect these changes.

Should you get a variable-rate mortgage and when does it make sense to get a variable rate instead of a fixed-rate loan? While variable rates sound promising, they are risky to consumers as the risk of paying a higher interest rate is inevitable, especially in a market where interest is increasing. This means your monthly payments will be unpredictable, hard to budget and plan for, and you may not afford payments especially when the interest goes higher during difficult times.

In this article, I will walk you through the dangers of variable interest rate loans and how to pick between a fixed rate and a variable interest loan.

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Variable vs. fixed-rate loans

Loans usually come in two major types: (1)variable interest rates loans and (2) fixed interest rates loans. Here is how these two types of loans differ from each other.

What are fixed-interest rate loans?

When you take out a fixed-interest rate loan, it means the interest on the loan will stay constant for the duration of the loan. Even if market rates increase or decrease, the interest you pay will remain constant. Having a fixed interest rate on your student loan, mortgage, or car loan also means you will have a fixed monthly payment for the duration of the loan.

A good example of fixed interest rate loans includes a 15-year fixed-rate mortgage and a 30-year fixed-rate mortgage. By electing a fixed-rate mortgage, you will know exactly how much your monthly payments will be which helps you plan and budget for your loan payments and other financial obligations.

For example, if you have a 30-year fixed-rate mortgage at 5%, this rate will stay the same for 30 years or until you pay off the house in full or refinance.

What is a variable interest rate loan?

Contrary to a fixed-interest rate loan, a variable interest rate loan means the interest on the loan changes over time. The lender changes the interest rate on a variable-rate loan in response to changes in market rates. If market rates increase, the interest rate you pay on the loan will go higher. On the other hand, if market rates drop significantly, the interest rate you pay on the loan will decrease.

For example, if you have a 5% interest rate on a mortgage and market rates drop to 2.5%, the mortgage servicer will lower the interest rate on your mortgage to reflect these changes. When you sign up for a variable-interest-rate loan, you usually start with a fixed rate for a few years before switching to an adjustable interest rate. For example, you can have a 5/1 variable rate, meaning for the first 5 years, you will pay a fixed interest rate and then switch to a variable interest rate every year after that.

Is it a good idea to take out a variable interest rate? What are the dangers of taking out a variable interest rate loan?

Variable rates are riskier to consumers in a market where interest rates are rising. For example, if the market rates rise from 5% to 20% in a few years, the interest on your loan could rise much higher and become unaffordable.

What is the danger of getting a variable-rate loan?

Getting a variable interest rate loan is risky because the lender might increase the interest rate at any time making it harder to afford your monthly payments.

Due to this risk, variable interest rates loans have what is known as interest caps which determine different levels your lender can increase the interest rate. The following are three variable interest rate caps and how they affect your monthly payments.

Initial cap. The initial cap indicates the highest interest rate on a variable interest loan can be adjusted initially. For example, if the initial cap is 6%, the lender can adjust the interest rate to no more than 6%.

Periodic cap. The periodic cap shows how much the interest can be increased or reduced whenever the lender adjusts your interest at any given period. For example, if the periodic cap is 2%, your lender can only increase or lower your interest rate by a maximum of two percent. If your loan rate is 5%, the lowest the lender can lower your rate is 3% when markets are lower or up to 7% when market rates are higher.

Lifetime cap. The lifetime cap determines the highest interest you can be charged for the entire loan term. This cap is in place to make sure you can still afford the loan even if market rates skyrocket beyond affordability. For example, if the lifetime cap is 10%, the maximum interest you will be charged on your loan is 10% even if market rates increase to 30%.

You might also like: How can you reduce your total loan cost?

What are the pros of getting a variable-rate loan?

When you take out a variable interest rate, the lender usually starts you at a much lower interest rate because of the extra risk you are taking. Here are the pros of taking out a variable interest rate loan.

Your monthly payment might be affordable due to paying a lower intro rate.

You can qualify for a much lower interest rate than you could have approved if you took out a fixed-rate loan.

If market rates decrease, the interest rate on your loan will increase, making the loan expensive.

What are the cons of taking out a variable-rate loan?

Taking out a variable interest rate loan comes with a lot of dangers. Perhaps the biggest danger of taking out a variable interest rate loan is the risk of paying a higher interest rate. Here are the risks of taking out a variable-rate loan.

You cannot budget for your monthly payments as the interest rate you pay depends on market rate changes.

If market rates increase, the interest on your loan will increase costing you more money
Your monthly payments will go higher in a market where rates are increasing.

What are the pros of fixed-rate loans?

If you are looking for loans and mortgages, you might need to stick to fixed-rate loans. Generally, fixed interest rate loans are better than variable rates for consumers. This is because you can predict and budget for your monthly payments. Additionally, you escape the risk of paying higher monthly payments when market rates increase.

Here are the benefits of getting a fixed interest rate.

The interest rate on the loan stays constant for the duration of the loan

Your monthly payment stays the same

You can know the total cost of the property from amortization schedules

It is easy to budget and plan for your monthly payments

What are the cons of getting a fixed-interest rate loan?

While taking out a fixed-interest rate loan is the best and safest option for consumers, fixed rates also come with some disadvantages. Paying a fixed interest rate, for example, means you won’t benefit from lower interest rates when market rates decrease.

Here are the cons of taking out a fixed-interest rate mortgage/loan.

If you qualified for a higher interest rate, you will need to refinance to lower your rate

You usually get approved for a higher interest rate than rates on variable interests.

If market rates go lower, you will not benefit since fixed rates stay the same unless you refinance

Why should you avoid a variable-rate loan?

A variable interest rate loan means the interest on the loan will change over time. While the lender will initially offer you a fixed rate for a few years before the variable rate kicks in, you might still pay a much higher interest rate if market rates increase. Paying a higher interest rate also means that your monthly payments will be higher which could be unaffordable depending on your financial situation.

It is also hard to predict and plan for your monthly payments when you take out a variable-interest-rate loan. This is because the interest you pay depends on market rates. If market rates increase, the interest on your loan will go higher and you will pay higher monthly payments. On the other hand, the lender will lower the interest on your loan when market rates decrease resulting in lower monthly payments.

When does it pay off to get a variable-rate loan?

Given the risk of getting variable interest rates loans, you might be wondering if you should sign up for these kinds of loans is a great idea. Every type of loan comes with pros and cons and taking out a variable loan also comes with some advantages. The biggest benefit of variable rates loans is that they often come with a lower initial interest rate compared to fixed-rate loans.

This means your initial monthly payments will be lower and more affordable. You could also qualify for a much higher loan principal due to a lower interest rate. Additionally, it pays off to take out a variable interest rate when you anticipate market rates to go lower as your interest rate gets adjusted to reflect changes in market rates.

Should you get a variable rate or a fixed rate?

If you are taking out a loan, it is safer to get a fixed-rate loan as these loans come with relatively low risks for consumers. Not only that you pay the same interest rate for the duration of the loan, but you can also predict and budget for your monthly payments. Additionally, you will know ahead of time the total cost of the loan and how much you will spend to pay off the asset in full.

Even if you qualify for a higher interest rate, you can refinance your loan when rates decrease. Fixed rates also protect you from paying higher interest rates as your rates stay the same regardless of market conditions.

If you apply for a loan when market rates are higher and anticipate rates to take a downward trend, you might save money by taking out a variable interest rate loan. First, your lender might qualify you for a lower interest rate on a variable loan for the first few years due to the extra risk you are taking. Additionally, you will pay a lower interest rate without refinances when market rates decrease.