Fixed or Variable, What Interests You?

HOUSES! Magazine October 2011

While there are numerous financing options available for borrowers, many are simply variations of a fixed rate loan or a variable rate loan. This article addresses the basic distinctions. There are many, and often more complex, factors in choosing between and fixed rate loan or a variable rate loan.

A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. The rate can be tied to many indexes, with the Wall Street Journal Prime Rate being one of the more common. As a result of the interest rate being tied to an index that may change, your payments will vary with the fluctuations of the interest market. Variable rate loans often have a rate that is initially lower than a fixed rate loan, however, given the fact the rate can change, the variable rate carries the risk of the rate, and payment, increasing. Conversely, the borrower may benefit from a falling rate and falling payments. Another factor to consider is most variable rate loans will at some point in the future convert to a fixed rate at the then prevailing marker interest rates. Consequently, there is uncertainty in the final rate and thus the final monthly payments.

 Fixed interest rate loans are loans in which the interest rate charged on the loan will remain fixed for the loan’s entire term, regardless of the direction the market interest rates take. This will result in your payments being the same over the entire term. While this affords a borrower more stability and certainty in the monthly payments, this comfort usually comes with a higher initial interest rate than a variable rate loan.

 Whether a fixed-rate loan is better for a borrower will depend on a borrower’s comfort level with potentially changing payments. If stability in monthly payments is important to a borrower the fixed rate may be a better loan. If a borrower would rather have a lower initial interest rate and is comfortable with the uncertainty in the monthly payment amount over time, the variable rate may be a better product.

 Another consideration is the interest rate environment when the loan is taken out and on the duration of the loan. When a loan is fixed for its entire term, it will be fixed at the then prevailing market interest rate, plus or minus a spread the lender determines for the particular transaction. In general, if interest rates are relatively low, but are increasing, then it will be better to lock in your loan at that fixed rate. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan. With respect to the term of the loan, the longer the term the more consideration must be given to long term savings on interest as well as the potential for numerous high and low interest rate cycles.

 While every borrower’s situation and tolerances are different, and it is very difficult to predict the direction of the interest rate markets over time, adjustable-rate loans are generally beneficial for a borrower in a decreasing interest rate market, and fixed rate loans are generally beneficial in an increasing interest rate market.

 Ron Pennington is Chair of the Real Estate & Financial Services Practice Group at BoltNagi PC, a full service business law firm located on St. Thomas, Virgin Islands.  Attorney Pennington concentrates his practice in commercial and residential real estate, acquisition, development and financing. To contact Attorney Pennington, please email: [email protected] or visit www.vilaw.com