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What is the difference between a fixed and a variable interest rate?
A fixed interest rate means that the rate of the finance charge does
not change throughout the duration of the extension of credit. For
example, an automobile dealer may offer a loan for an automobile at
4.9% interest rate for 24 months; this means the interest rate is fixed
at 4.9% for the duration of the loan (which is an installment
closed-end credit loan).
Under a variable rate loan, the
finance charge is determined by an index, such as the "prime rate"
published nationally each quarter for short term loans charged by
banks. This form of loan enables the lender to charge an interest rate
that reflects current market conditions. Many credit card issuers
charge a base interest rate (such as 4.9%) plus the indexed rate (such
as prime rate) to assure them adequate return on the loans that they
extend. This mean your payments could decrease over the course of the
loan, but they might also go up suddenly.
When shopping for
credit, keep in mind that there is a difference between fixed and
variable rates. Some lenders now extend credit on a fixed basis, but
only for a short time, after which the interest rate becomes variable.
It is important for you to read the fine print of the contract to know
how the interest rate will be set and how it may change.
There
are advantages and disadvantages to each kind of loan. Variable rate
loans often have additional options, like accelerated repayment without
penalty that might be valuable to you. There is more flexibility with
these loans and more competition among lenders that might keep rates
down. Fixed rates, on the other hand, give you security and stability,
and let you plan for the future with certainty.
To determine
which is better for you, crunch the numbers, determine the amount of
credit you will use over the life of the loan, and apply the applicable
credit rate. You could discover that a higher initial APR will result
in a lower finance charge over the duration of the loan.
It's
sometimes possible to split your loan into a variable/fixed loan
hybrid. For example, you could split the loan 50/50 or 35/65. To decide
if this is a good choice, you still need to crunch those numbers and
find out what fees and penalties apply.
(Reviewed 10.31.2008)
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