At first glance, understanding variable versus fixed interest rates looks like a no-brainer. Commonly associated with loan finance, one of the rates will vary over time, while the other is permanently set. However, there’s much more to understanding variable and fixed interest rates and how to use them to your benefit.
Financial instruments which use variable and fixed interest rates
Financial instruments which use variable and fixed interest rates include:
- Personal loans
- Business loans
- Mortgages
- Credit cards
- Corporate bonds
- Government bonds
- Savings accounts
This is just a small selection of financial instruments that can use variable and fixed interest rates. Many of us will know about personal loans and mortgages, but we may not be aware of others. Consequently, it is essential to be mindful of the pros and cons of variable and fixed interest rates and how they work.
What are variable interest rates?
In simple terms, variable interest rates relate to the interest charged on loans. The rate may go up or down throughout the loan, impacting the interest charged on the outstanding loan and future repayments. It also prompts the question: What is the variable interest rate linked to?
In the UK, historically, variable interest rates have been linked to:
- Bank of England base rate
- London Interbank Offered Rate (LIBOR)
- Sterling Overnight Index Average (SONIA)
The SONIA rate, one of several risk-free rates available, replaces LIBOR, which was phased out at the end of 2021. As a result, historic financial arrangements which use LIBOR are being encouraged to transition to SONIA or another appropriate risk-free rate benchmark.
These rates indicate general lending rates, although the connection between a benchmark rate can be formal or informal.
Informal connection
You will find that some variable interest rate agreements are “loosely” linked to the chosen benchmark. So, for example, with UK variable rate mortgages, an increase in the Bank of England base rate would likely see an increase in the mortgage interest rate. However, it may not be on a like-for-like basis, with supply, demand and market conditions also playing a part.
Formal connection
Alternatively, some variable loan rates will be based on a more formal arrangement. A common one might be the Bank of England base rate plus 2%. So if the Bank of England base rate were 1.5%, the variable interest rate would be 3.5%. If the Bank of England base rate fell to 1%, the variable interest rate would fall to 3%.
What are fixed interest rates?
As the term suggests, fixed interest rates are generally fixed for the duration of your loan. In the UK, you tend to find that fixed interest rates are more closely associated with short-term finance, like personal loans. However, when it comes to longer-term finance, a 25-year mortgage being a prime example, there tends to be an element of variable interest rates at some point over the term.
Short-term fixed interest rates
As mortgages are among the more popular types of finance in the UK, we will use this as an example of short-term fixed interest rates. When applying for a variable-rate mortgage, a lender may offer a range of short-term fixed interest rates. This could cover, for example, one year, two years, three years, and so on of a 25-year mortgage. Once the fixed interest rate term ends, the arrangement will automatically revert to a variable-rate mortgage.
At this point, many people look to secure another short-term fixed interest rate. However, this may vary from the original if underlying interest rates have moved. In addition, switching to another fixed-rate deal may also attract charges from your lender.
The pros and cons of variable and fixed rate financial arrangements
At first glance, many people are drawn toward fixed interest rates because this allows them to plan their finances with a degree of certainty. The interest rate on their loan may be fixed for the duration or part of the term. However, it is vital to know the pros and cons of variable and fixed rate interest charges.
Variable interest rates
Over most of the past 15 years, we have seen a significant reduction in base rates across the UK and worldwide. Initially, this was prompted by the 2008 US mortgage crisis and, later, the challenges of the Covid-19 pandemic. Rates then began to rise again in late 2021.
Pros of variable interest rates
There are some positives when looking at variable interest rates, which include:
- Immediate benefit if interest rate benchmark moves lower
- Potential for reduced interest payments
- Initially, variable interest rate products tend to be lower than fixed-rate products
Cons of variable interest rates
In essence, the benefits of variable interest rates come into play when interest rates are trending downwards. Consequently, there is some downside when rates are rising, including:
- Immediate increase in interest rate if benchmark moves higher
- Potential for rising interest payments
As it is impossible to look too far into the future, many prefer to look towards fixed interest rate products. However, as we have seen over the last ten years, this is not always the most beneficial option!
Fixed interest rate
Whether you have been able to negotiate a temporary fixed rate or one for the whole duration of your arrangement, there are several pros and cons to consider.
Pros of fixed interest rates
When looking at the benefits of fixed interest rate financial products, two main benefits spring to mind:
- Regular fixed payments allow you to plan your finances
- Beneficial if the interest rate benchmark moves higher
Cons of fixed interest rates
On the flip side, there are some issues to be aware of with fixed-rate financial products, which include:
- Rate remains fixed at a high level even if interest rate benchmarks are trending downwards
- Fixed interest rate products often attract a higher initial rate than their variable counterparts
Deciding between fixed and variable mortgage interest rates
As a borrower, you must determine whether you should choose a fixed or variable rate for your mortgage. Knowing more about these rates and how they work can help you make a more informed decision.
It is essential to remember the pros and cons of taking out a fixed-rate mortgage and a variable-interest-rate mortgage. Whether you are a first-time buyer, moving home, or remortgaging, this is a significant decision that requires a lot of thought, as it can have a considerable impact on your financial situation both in the short-term and longer term.
For instance, you are charged a higher than average rate with a fixed-term mortgage. However, this rate does not fluctuate as long as the mortgage is fixed. This means that your monthly payments will remain the same throughout the fixed period, making budgeting easier and providing greater peace of mind. This is why many borrowers decide to go for a fixed-rate loan during the home buying process, as rate rises will not affect them for a specified period.
With a standard variable rate mortgage or a tracker rate, you can generally get a lower interest rate, but your interest rates can rise and fall in line with the base rate from the Bank of England. This means your mortgage repayments can go up or down depending on what the base interest rate is doing.
Of course, you must remember that whether you take out a new mortgage or decide to refinance, your credit score will significantly impact the mortgages and rates you are eligible for. Those with bad credit will be charged higher rates by mortgage lenders on both fixed interest rate mortgages and variable interest rate ones.
These are all key points to keep in mind when it comes to deciding between a fixed or variable rate mortgage or any other type of finance.
Traditional markets: Variable rates tend to be lower than fixed interest rates
Traditionally, variable rates on products such as mortgages tend to be lower than their fixed interest counterparts when penning your financial agreement. This premium is added to the variable rate to calculate the fixed rate as a hedge against a potential future increase in interest rates. A lender will benefit from a variable agreement, as they can increase rates immediately, whereby a fixed interest rate will remain static.
While uncommon, there can be some exceptions if interest rate benchmarks are relatively high and expected to fall significantly throughout your finance agreement. In this somewhat unique scenario, you may see fixed rates lower than their variable counterparts. Possible but unlikely is the best way to describe this.
Understanding how interest is calculated
Two factors stand out amidst the pros and cons of variable and fixed interest rates. First, a fixed rate gives stability and the ability to plan ahead. In contrast, variable rates are most beneficial when interest rates fall. When it comes to mortgages and other financial arrangements, you may be able to negotiate short-term fixed rates but would then switch back to variable rates. Whatever your preference, it is essential to take financial advice to ensure you make the best decision for your specific situation.