So let’s say you are in the market for a new loan. You need to figure out what annual percentage rate (APR) you want before signing the dotted line. By figuring out what APR you want, I mean you need to decide whether you want a variable rate or a fixed rate on your loan. They definitely aren’t the same thing! Despite being big and bad financial terms, it is easy to understand what they are and how they differ from each other.
So let’s cover a few basics about APR before moving forward. An APR is calculated over the entire year, but it is applied monthly. This means that if you had a 24 percent APR, then you are charged 2 percent each month. The APR defines how much interest you are going to owe from the last month, and that interest amount is tacked on to your principal balance. Well, there is a small lesson in interest payments right there. It wasn’t all inclusive, but it works for this article.
What is a Variable APR?
So here is a quick spoiler: variable APRs change or vary with time. How do they change exactly? Well, they are dependent of the fluctuation of the market. So look at it this way with my quick, cheap example. One year you get a loan with a variable APR of 2 percent because interest rates are low in the market overall. After five years with the loan, you notice that your APR has now doubled to 4 percent. This is because you picked the variable rate, and it is subject to change depending on the market. That scenario sounds awful, but it’s a two-way street, meaning your interest rate could decrease over the same time period. Think of it as a gamble of sorts.
I keep mentioning the market, but I haven’t explained it yet. There is this rate that all of the big banks and groups lend to each other in the stock market. It may differ in name from market to market, but generally, there is a base rate that the big dogs base their rates on. In the United States, the Federal Reserve sets this base rate. All of the lenders tack on basis points (another term for percentage basically) to this rate. There you have it.
What is a Fixed APR?
A fixed APR is a much simpler horse to handle. Like a variable rate, a fixed rate is determined by the market at the start of the loan, but instead of changing over time, it remains fixed at that rate upon disbursal of the loan. It offers more certainty than a variable rate loan because there is no risk of your rate increasing later on, but there is less potential to save on interest down the road.
What’s the Difference?
One of them changes and one of them doesn’t! A fixed rate offers more certainty by keeping the rate stable, but it leaves out the potential for a reduced rate later. A variable rate offers the potential for a lower rate later on, but it’s also much riskier than a fixed rate.