When borrowing money, the interest rate plays a crucial role in determining the overall cost of the loan. Generally, higher interest rates mean you'll end up paying more for the loan over time.

However, loans can come with different types of interest rates, so opting for the lowest rate isn't always straightforward. For example, when comparing fixed-rate and variable-rate loans, you'll need to consider additional factors such as the duration of the loan, the direction of interest rates, and your ability to manage potential rate increases in the future.

Car loans typically feature fixed rates, while credit cards often have variable rates. Many other types of loans, including home equity lines of credit, student loans, and mortgages, offer both fixed and variable rate options. Here’s what you need to understand to make an informed decision:

Fixed-rate loans

A fixed-rate loan maintains the same interest rate throughout its entire term, ensuring that your payment amount remains constant over the life of the loan.

Advantages: Fixed-rate loans simplify financial planning because you know exactly what your payments will be both now and in the future. They also offer protection from rising interest rates, providing stability in an increasing rate environment.

Disadvantages: To gain this stability, you typically start with a higher interest rate compared to variable-rate loans.

Best for: Borrowers who prefer predictable payments or who intend to hold the loan for a long period. Since the longer the term, the greater the risk of rising interest rates, locking in a fixed rate offers the advantage of rate predictability.

Variable-rate loans

The interest rate on variable-rate loans, also known as floating-rate or adjustable-rate loans, fluctuates in line with changes in market interest rates. These loans are often linked to a benchmark rate, such as the LIBOR index, which banks use to set their rates. As this benchmark rate changes, the interest rate on your variable-rate loan will also adjust. Typically, your rate might be a set amount above the benchmark, such as 2 percentage points. The rate may adjust monthly or at other intervals specified in your loan terms, but there is usually a cap to prevent the rate from rising excessively.

Advantages: The initial interest rate on variable-rate loans is generally lower than that of fixed-rate loans. For short-term loans or when interest rates are decreasing, you might save money compared to a fixed-rate loan.

Disadvantages: If market interest rates increase, your monthly payments on a variable-rate loan are likely to rise as well, potentially leading to higher total costs than initially anticipated. Refinancing could be challenging if rates rise, as new fixed-rate loans may also come with higher rates.

Best for: Borrowers who can accommodate potential increases in their payments and can handle the possibility of paying the highest possible rate. Variable-rate loans may also be suitable for those who plan to hold their loans for a short period, as the risk of rising rates grows with time. They can be riskier in a low-interest-rate environment, as rates are more likely to increase in the future.

Bottom line:

Along with assessing your budget, it’s crucial to consider the current market interest rates. If rates are high, a variable-rate loan might be advantageous over the long term if you plan to keep the loan for an extended period. Conversely, if rates are low, securing a fixed-rate loan with a low rate could be more beneficial.

No matter which interest rate option you select, maintaining a good credit score will help you secure the most favorable rate available.