title. i understand the difference between variable and fixed as definitions however with loans, ‘variable’ doesn’t quite register to me..
why on earth would someone consider that type of loan with a purchase of let’s say, a house?
In: 43
Why would someone consider one?
99% of the time, ignorance.
A variable rate isn’t truly a free variable, it’s usually tied to a benchmark, like the interest rates set by the Fed (or the central bank of another currency). If you have a variable rate loan, and your bank raises the interest rate much higher than the Fed rate, you can just go to another bank, and take out a loan to repay that loan.
Someone can loan you the money at a higher rate than the benchmark but lower than the one charged by your current bank. The amount you owe won’t change, and you got approved for the first loan, so it’s not any riskier to approve your new loan. Bank 1 will lose out on interest, Bank 2 makes a bit of profit with low downside risk. It’s similar to how people take out one time loans to pay off their credit card debt.
The advantage of variable rate is
1. It may be lower than fixed rate. A fixed rate loan has to factor in risk of inflation/rising rates, so it will typically be higher than the variable.
2. The variable may stay lower than the fixed rate the whole time or most of the time. It can even drop lower than it started. You’re betting on the future.
With a variable loan, the interest rate varies. With a fixed loan, the interest rate stays the same throughout the duration of the loan. Sometimes variable loans have lower rates, and often times they have caps on how much they can increase in a given year. So if you take out a variable loan and the rate starts increasing too much, what you might do is “refinance” it — essentially have another lender buy the loan for you and then enter into a contract with that lender at another (fixed or variable) rate.
As an example, I took out a student loan for grad school about 6-7 years ago. The fixed loan rates were around 6.5% at the time. The variable loan rate was 2.99%. Because of this difference, I chose variable. The variable rate increased about 0.6% each year, and had a cap on how much it could increase per year. By the time I paid it off, it was around 6%, but for much of its life it was lower. Had I taken a fixed rate loan, it would have been 6.5% the whole time. It was still worth doing variable even though the rate increased over time — I saved a lot of money from lower interest rates. My loan rate could have also decreased and, if it increased too much I could have refinanced and taken a fixed or different variable loan.
Adjustable rates go off of the purchasing power of the money I stead of the dollar amount. So through changes is the economy and inflation your rate will change.
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