4 times a variable APR makes sense
When taking out a loan, it pays to weigh the pros and cons of a variable interest rate.
- Variable interest rates make sense in specific situations, such as when you plan to buy and sell a home in a few years or want to pay off a loan early.
- Variable rate loans, however, can be risky as interest rates can rise.
- Fixed rate loans are almost always more reliable and easier to budget for.
When it comes to borrowing money, one of the decisions you will need to make is whether you want a variable rate or a fixed rate loan. A variable interest rate is a rate that goes up and down over time. Since floating rates are tied to an underlying benchmark interest rate, they mimic what happens with that underlying rate. For example, the variable interest rate increases if the reference rate increases.
Although fixed rate loans are more common, you might be surprised to learn that an adjustable rate loan is best for you in certain situations. Here are four.
1. You don’t expect to keep a loan for long
Let’s say you’re moving to a new city, but know that you’ll only be there for two or three years. You buy a house and find that the variable interest rate is lower than the fixed rate. The less you carry a variable interest rate mortgage, the less likely it is that the underlying benchmark will rise and your variable rate will rise. It may therefore be wise to opt for a variable rate when you know that you are not going to keep the loan for long.
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Another example would be if you are expecting funds from an annuity, life insurance, or work bonus. If you’re borrowing money in the months leading up to that big payday (and plan to pay off the loan with the money), a variable rate can save you money because of the lower interest rate.
2. You think interest rates will go down
Like the weather, interest rates can change from day to day. If you’re borrowing money and everything points to lower interest rates, taking out a variable rate loan means your monthly payment could go down as well. That said, if you’re wrong and the interest rate goes up, you’ll see your payments go up.
3. You use the monthly savings to repay the principal
Imagine you take out a $50,000 debt consolidation loan. The fixed interest rate is 6% and the variable rate starts at 4%. The term of the loan is 10 years. By opting for the variable interest rate, you will save approximately $50. If you plan to use those monthly savings to repay the principal (the original amount you borrow), you’ll not only prepay the loan, but you’ll also save over $1,200 in interest.
The catch is that this plan only works if the variable interest rate doesn’t increase before the loan is paid off. The longer you have a variable interest rate, the higher the rate will increase.
4. Accepting a variable rate is the only way to qualify for the loan
If you are making a major purchase, such as buying a house or land, and you don’t qualify for a fixed rate mortgage, you may qualify for a variable rate mortgage. lower interest and a monthly payment.
However, if what separates you from a loan is a slightly higher interest rate, you may want to reconsider the purchase, at least for now. The fact that you do not qualify for the fixed rate loan indicates that you may be taking on a larger obligation than you can comfortably afford.
The bottom line is this: A variable rate loan generally only makes sense in specific situations. A fixed rate loan allows you to budget knowing that your loan payments won’t increase over time. If you can get a low enough interest rate on a fixed rate loan, it’s almost always the most reliable choice.
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