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Comparing Variable & Fixed Interest Rate Loans

Comparing Variable & Fixed Interest Rate Loans
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  • 0:00 What Is Interest?
  • 1:00 Lending and Borrowing Money
  • 1:55 Variable Rates Vs. Fixed Rates
  • 4:59 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Most people, at some point in their lives, will experience the process of getting a loan - perhaps for a house, car, education or something else. This lesson will describe the difference between the two types of interest rates commonly offered.

What Is Interest?

Before we can compare variable and fixed interest rates, we need to have a solid understanding of why borrowers pay interest in the first place. It's all based on one basic economic concept: the time value of money. While it can be a complex concept, the general idea can be understood with a candy bar.

Remember the candy bar your grandparents told you that they bought for a nickel as a kid, the same one that now costs you a dollar? Did the candy bar change? Not much, if at all. In fact, the way the candy bar is made is probably more efficient, so if anything, you'd think the price might go down. But, what happens when money loses its value? Prices go up. In finance and economics, this is known as inflation. Since borrowers borrow money now and lenders get the money back in the future, they have to charge interest, money paid by a borrower for the use of borrowed funds, to make sure they aren't losing purchasing power.

Lending and Borrowing Money

Consumers, businesses, and even governments lend and borrow from one another every day. If you've ever been part of this credit market, you know interest rates are an important part of the terms of a loan. The principal is the amount you borrow, and the interest rate is the percentage of the principal you pay back, on top of the original principal. Let's run through a very simple example to make sure this all makes sense.

You want to buy a car for $10,000, and you've decided to finance 100% of the car. That means you need to find a bank to loan you $10,000. You've been a customer of your local credit union for a number of years, have good credit, and since you'll have collateral (the car), they offer you an interest rate of five percent. That means, in the simplest of terms, you'll pay back the bank the $10,000 over time, plus you'll pay them $500 extra ($10,000 * .05) in interest.

Variable Rates vs. Fixed Rates

There are two common situations - credit cards and mortgages - when a lender might want to charge you variable interest rather than fixed interest. But why, and what's the difference? The quick answer is that a fixed interest rate stays the same for the life of the loan. In the earlier example of you borrowing $10,000 for a car, the interest rate was five percent until the loan was paid back; it was fixed. A variable interest rate changes at an agreed-upon interval, based on some predetermined benchmark interest rate, such as the prime rate of the federal reserve.

What's the advantage of a fixed rate? Going back to the car example, if you had agreed on a five-year term, your payment would be about $189. Because your rate is fixed and the amount you owe is paid off over a defined time period, you can budget based on that same $189 per month. Fixed rates allow for precise budgeting. The same is true for the lender. The credit union that lent you the money can expect that $189 payment each month, so it's easy for them to project revenue. No guesswork, no changes. Just the same, fixed payment.

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