The main differences between fixed rates and variable rates are how the rate fluctuates and how it alters your repayment amount and overall cost of lending. Various types of loans can have either a fixed or variable rate, and depending on your business needs, either rate option may be applicable. By understanding how both rate types work, you can determine borrowing costs and how to manage repayment expectations.
What Are Fixed vs Variable Rates?
Fixed interest rates are applicable to financing options that will have the same rate of interest throughout the financing term. Essentially, the rate remains constant, and the repayment amount required—usually with principal and interest—is paid in equal installments until maturity.
In a favorable market, fixed rates may be low and therefore allow for an affordable repayment schedule throughout the life of the loan. The opposite can be said in the case of a market downturn, as rates may increase and you might be stuck with a high interest rate over the course of a loan, resulting in higher repayment amounts and overall lending costs.
Meanwhile, variable interest rates—also commonly known as adjustable or floating rates—are used when a financing agreement has a rate that can be adjusted throughout the term. This means that rates can increase or decrease based on market conditions and that the expected repayment amount can change based on the current rate.
Variable rates are more common with short-term financing options and can be useful in favorable market conditions when rates are low and save money in overall financing costs. That said, variable rates tend to pose more risk to the borrower since they are less predictable.
How Do Fixed vs Variable Rates Work?
Fixed rates are typically assigned using a benchmark rate index and a basis point margin.
- A benchmark rate index sets the base rate and can include the Secured Overnight Financing Rate (SOFR), the federal funds rate, and the Prime Rate. That said, the rate index chosen can vary depending on the financing type and lender.
- You’ll also likely be subject to a basis point margin (or credit spread) that is added on by the lender. This margin can be either positive or negative and will be used to determine the total rate and cost of financing.
Together, these factors make up the designated interest rate, which will remain constant throughout the financing term.
The below example represents how a fixed rate might be calculated and how it will impact the repayment schedule of a loan or other financing agreement.The rate of interest will be calculated based on the following equation:
Benchmark rate index + Basis point margin = Interest rate
Let’s say we have a $100,000 loan with a 10% fixed interest rate and a 10-year loan term. With a fixed rate, the principal and interest payments required will be made in equal installments over the course of the loan.
Benchmark rate index (8%) + Basis point margin (200 bps) = 10% Interest rate
Split over 120 principal and interest payments, the borrower would be expected to repay a monthly amount of $1,321.51. This includes installments of the total principal loan amount of $100,000 and $58,580.88 in interest, for a total cost of financing of $158,580.00.
If you’re seeking financing and want to know what your repayment schedule may look like, check out our loan amortization template to help you calculate your monthly payment and total cost of financing.
Similar to fixed rates, variable interest rates are also assigned based on a benchmark rate index and basis point margin. When the benchmark rate changes to align with current market conditions, so does your assigned interest rate. This can reflect both an increase or decrease and impact your rate structure accordingly.
As the rate changes, so does the expected repayment amount. If market rates are high, you’ll pay more over the course of your financing term, whereas if rates are low, you could save money when compared with fixed rates.
For a scenario involving variable rates, let’s use an example that demonstrates how the rate might change. In this sample, we’ll assume the lender is using the Prime Rate as the benchmark index rate and appoints a basis point margin of 200. That would look something like:
8% (Prime Rate) + 2% (200 bps) = 10% interest rate
Now, since this is a variable rate, the Prime Rate is subject to change periodically and will impact the current variable rate assigned to the loan. For example, say market conditions allow for a Prime Rate adjustment with a decrease of 50 bps, therefore lowering the base rate to 7.50%. The rate structure of the financing agreement would then also adjust accordingly to account for this 50 bps rate decrease, and the new variable rate would be 9.50%.
Pros & Cons of Fixed & Variable Rates
| Pros | Cons |
|---|---|
| Fixed Rate | |
| You’ll know exactly how much you are expected to repay monthly. | Your monthly payments could be more expensive compared with variable interest rates. |
| You’ll be protected from variable market conditions impacting the fluctuation of interest rates. | Fixed rate loans typically have longer repayment terms, making costs of financing more expensive overall. |
| You can take advantage of being locked in to affordable rates when market conditions are favorable. | You’ll have lesser flexibility with loan terms with a fixed rate financing agreement. |
| Variable Rate | |
| Rates can be cost effective and suitable for short-term financing needs. | Rates are subject to change at any given time to align with current market conditions. |
| Borrowers could save money if rates are low throughout the course of the loan. | Payments can fluctuate throughout the course of the financing term and interrupt the cash flow of the borrower. |
| Rates offer more flexibility in terms of loan structure and financing options. | Total costs of financing can be more expensive over time if rates rise. |
Common Types of Financing for Fixed & Variable Rates
Both fixed and variable rates are commonly used for a wide variety of financing types. Depending on your financing needs and preferences, you can work with your provider to determine the best rate type for you. That being said, fixed interest vs variable interest should be factored into your budget, financing term, and funding amount.
| Financing Commonly Associated With Each Rate | |
|---|---|
| Fixed Rate | Variable Rate |
|
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For information on the application and approval process of these financing types, check out our guide on
how to get a small business loan
.
When to Choose a Fixed vs Variable Rate
In some cases, you’ll be presented with both a fixed or variable rate option when applying for financing. This won’t always be the case, as some forms of financing may only have one option applicable, or perhaps the lender is only willing to pursue one option. In the event you are given a choice between the two rate types, see the use cases below to compare what each may be best suited for.
Fixed rate financing can have both advantages and disadvantages and might be the right choice for borrowers who:
- Have a strict budget: With a fixed rate, you’ll have the same payment amount every month. For businesses with a strict budget, this may be beneficial so you can plan accordingly and manage your finances without surprises.
- Need long-term financing: A fixed rate might be the best option because in the event market rates were to adjust over time, you won’t be subject to varying payment amounts and/or rate increases.
- Have minimal risk tolerance: For borrowers with limited flexibility or resources, a fixed rate can help mitigate risk and provide you with peace of mind knowing that your rate and repayment schedule will be consistent.
Variable interest rates are less predictable and should be carefully considered before entering into an agreement. They may be best suited for borrowers who:
- Need short-term financing: If you plan to pay off your loan quickly, variable rates may benefit you if current market rates are low. You could also save on the overall cost of financing since it’s a short amortization period with potentially low rates.
- Want to take advantage of favorable market conditions: When market conditions allow for favorably low interest rates, you can take advantage of the market if your risk tolerance allows.
- Are comfortable with potential risk: Variable rates are known for being unpredictable and can change at any given time. You should be comfortable with this level of instability and make sure your budget allows for rate fluctuation, both positively and negatively.
Factors to Consider When Choosing Between a Fixed or Variable Rate
If you’re in search of financing options and trying to determine whether or not you’d prefer a fixed or variable rate, you’ll need to consider your qualifications and preferred loan terms. In some cases, you may not have the option of both rate types, depending on the type of loan and your credit worthiness as a borrower.
When choosing between variable vs fixed rate loans, there are a few common factors to consider. These include:
- Determine your budget. You should consider if you can afford a fluctuating rate in the instance rates increase, or if it’s best you have a fixed payment to better manage your monthly payments and keep on top of your budget. Take a look at your current personal and business finances to make sure you can cover payments, regardless of the rate type you choose.
- Evaluate the risks. Research current market conditions and consider your risk tolerance. If rates are rising, it may be wise to enter into a fixed rate agreement to avoid further increases. If rates are favorably low, you could take advantage of a variable rate that has potential to decrease further.
- Review short- or long-term financing options. You’ll want to account for the amortization schedule of the loan, and whether or not your need for financing is short- or long-term. This is due to the fact that the longer the amortization period, the more you’ll be expected to repay overall.
- Compare the total costs of financing. If you’re presented with both fixed and variable rate options, it’s worthwhile to calculate and compare the total costs of financing. While you can’t always anticipate the final costs with a variable rate, try to determine what you can afford and how it’s applicable to the type of financing you need.
If you’re looking to get a business loan that offers both fixed and variable rate options, consider Lendio. It has a wide variety of small business loans to choose from with favorable rates and terms and can connect you, as a broker, with multiple providers with a single application.
Frequently Asked Questions (FAQs)
How often can a variable rate change?
Variable rates can change at any given time in accordance with the benchmark rate index they’re associated with. The rate index can fluctuate based on market conditions and may increase or decrease upon review.
Is it possible to switch from a variable to a fixed rate later?
Yes. Most lenders offer options for loans with variable rate structures to later be converted into a fixed rate structure. Usually this comes with a fee and further documentation requirements necessary to make the switch.
Are there penalties for switching rate types?
It depends. In some cases, you may be subject to a prepayment penalty fee if the switch violates the terms of your financing agreement. There also may be other fees or documentation necessary, in which you should speak with your provider to walk you through the process and to ensure expectations are met.
Bottom line
The differences between fixed rates and variable rates can impact your need for financing based on market conditions, your risk tolerance and budget, and your preferences as a borrower. For borrowers who want to take advantage of favorable market rates and are comfortable with changing rates, a variable rate may be the best fit. For those wanting a more structured monthly payment without variance, a fixed rate is likely suitable. Be sure to consider these factors before making a decision and signing an agreement.
