Understanding Fixed and Variable Interest Rates in an Unpredictable Market
Interest rates drive the way we borrow money and manage our finances. Depending on what kind of market and rate environment we're in, adapting to how we save, spend, and borrow money is essential to financial success.
It's no secret that interest rates have been steadily on the rise. For money savers with share certificates and savings accounts, it's an excellent position to be in. Typically, in a rising interest rate environment, financial institutions raise yields in an effort to attract more deposit activity. The higher the yield, the better the earning possibilities. For borrowers in need of lending solutions, it's the complete opposite, especially when you take the market and type of loan you have into consideration.
Rate increases can significantly influence our economy and affect the way we manage our finances. So, it's critical to understand the different types of loans and their intricacies and what's best in an unpredictable economy.
How do Federal Funds Affect Interest Rates?
Within the last couple of years, you've undoubtedly seen countless news headlines that refer to the Federal Reserve, inflation, the rise of rates, federal funds, and prime rate. But what exactly does all of that mean and how are they related to one another?
One of the Federal Reserve's responsibilities is to maintain and promote a strong, healthy economy. And one of their primary objectives is determining the cost of borrowing money. They set a benchmark interest rate, known as the federal funds rate (or fed funds rate). Fed funds are intended to be used as an economic tool that controls financial supply and offsets inflation when the economy is overstimulated. The fed funds rate has an impact on the interest rates that financial institutions charge for loans. In a thriving economic climate where everything is running efficiently, rates are relatively stable and more attractive to consumers, which may encourage them to borrow money. In an unpredictable economy riddled with uncertainties, interest rates increase at a rapid pace to make it more expensive for consumers to borrow in an effort to combat inflation.
Sounds exactly like what's been happening, right? From March of 2022 to now, the Federal Reserve has raised the fed funds rate by 5.5 percentage points. That number, to put it frankly, is astronomical. And it's had a significant impact on the way consumers bank and borrow money. These rate adjustments have, of course, stemmed from the effects of the pandemic and the impact on the supply chain. Limited supply with high demand creates inflation. Prices rise so that consumers buy less so the supply chain can catch up. Due to inflation and high rates, the cost of living inevitably increases, and borrowing money to finance your home, vehicle, education, and credit card purchases become that much more difficult, especially depending on your loan type.
What's a Fixed Interest Rate?
A fixed rate loan is a type of loan where the interest rate remains the same for the entire length, or term, of the loan. The interest rate cannot change, so borrowers can expect their monthly payments to remain the same throughout the lifetime of the loan.
Unlike a variable rate loan, fixed rate loans do not fluctuate based on market conditions; they instead offer protection against rate increases. The only time, if applicable, that your interest rate can change is if you have the ability to refinance your loan for a better, lower rate.
Fixed rate loans are the ideal choice for borrowers that need predictability. You can confidently borrow money knowing that your interest rate will remain the same despite what may be happening in the economy and market. For instance, most auto loans and home equity loans offer fixed rates, so whether it's your first or twentieth payment, your payment and rate won't change, so you'll always know how much to budget.
What's a Variable Interest Rate?
A variable rate loan is a type of loan where the interest rate varies; the rate fluctuates because it's dependent on market interest rate changes. Variable interest rates are typically found in loan products such as mortgages, lines of credit, and credit cards.
Variable rate loans follow economic trends. The biggest advantage with this loan type is found during a declining interest rate market. If rates are declining, then your monthly loan payment and loan rate will more than likely automatically follow suit and decline as well, thus saving you money.
In a rising interest rate environment, borrowers will find that the opposite happens and see their loan rates and monthly payments increase. To put it in perspective, let's say you've got a variable rate credit card with an APR of 10%. If the prime rate increases by 0.25%, then your rate will likely increase to 10.25% APR.
Which Choice is Best?
So, which is the better choice: a fixed rate loan or variable rate loan? Well, it truly depends on market conditions and the interest rate environment. It's important to carefully weigh the risks and rewards when choosing between a fixed rate and variable rate loan.
Let's say you've currently got a variable rate loan. Pre-pandemic, variable rates were an extremely attractive financing option for borrowers. The rates were super low, and there weren't many significant increases. But nowadays with market conditions and because variable rate loans are tied to the prime rate, the rate increases have been pretty consistent, and may leave you wondering how you're going to afford your monthly payments if all this keeps up.
Should you jump ship? Will rates keep going up? When can we expect rates to stabilize? Should you hit the pause button on pursuing your financing needs? These are all great questions, but with inflation still lingering, it's tough to say which direction the Fed will go next. They have certainly slowed down on how aggressively they've been making rate adjustments, which is a good sign, but it's safe to assume that we've just got to sit tight and see what's in store at the next Fed meeting.
In the meantime, we'd suggest exploring all your options and doing your research. Take time to shop around, compare rates, and understand the fine print to ensure that you get the best possible rate and term. Be sure to look into fixed rate loans to see if they'd be better suited for you financially. If you have an immediate need for a loan and you find rates that are within a range you're comfortable with, take advantage of it now; there's a very high chance that now may be the prime time for you to borrow.
The Choice Is Yours
Ultimately, the choice between a fixed-rate and a variable-rate loan depends on your financial circumstances, risk tolerance, and outlook on interest rates. Variable rate loans can be attractive when interest rates are trending low and expected to stay that way, or if you plan to own the loan or property for a short period. But on the other hand, if you prefer stability and want to avoid the uncertainty of future rate changes, a fixed rate loan may be the better option for you.
As with any financial decision, it's crucial to carefully assess your situation, consider your long-term financial goals, and be prepared for potential fluctuations in interest rates if you opt for a variable rate loan. If you're unsure which option is right for you, seek advice from our friends at GOLD Credit Union so they can help you decide on a lending solution that's best for you!
Visit goldcu.org or call 484-223-4200.
This post is a sponsored collaboration between GOLD Credit Union and Lehigh Valley Style.
