Fixed vs. Variable Interest Rates

Transcription

1 Fixed vs. Variable Interest Rates Understanding the Advantages and Disadvantages f Each Rate Type When shpping fr financial prducts, there are a lt f factrs t cnsider. Much has changed in the financial industry in recent years, and it can be tugh t figure ut which features best suit yur individual needs fr the varius financial prducts yu use in yur everyday lives. Here are sme insights int tw f them: fixed and variable interest rates, hw they wrk, why they may be different and when each f these rate types may be beneficial. Definitins Fixed Interest Rate: An interest rate that will remain at a predetermined rate fr the entire term f the lan, n matter what market interest rates d. This will result in payments remaining the same ver the entire term. 1) Variable Interest Rate: An interest rate that mves up and dwn based n the changes f an underlying interest rate index. 1) Hw Fixed and Variable Interest Rates Wrk Fixed Interest Rates When smene applies fr a lan with a fixed interest rate, the rate they will receive is typically determined at the time f apprval, and it des nt change fr the entire life f the lan. When lenders determine price pints fr their fixed interest rate prducts, they base them n market rates available at that pint in time. Lenders wh ffer credit-based pricing will ffer a range f rates n their fixed rate prduct, based n creditwrthiness. In that case, the better the applicant s credit scre is (r that f the csigner/c-applicant), the better their chances fr a lwer rate. The market rate, n the ther hand, depends largely n the length f the lan and ther features, and can vary based n market cnditins. This means that lenders may change the fixed rates they ffer t new applicants as market cnditins change cnsumers shuld review the lender s current prduct ffer befre applying fr a lan. There are a variety f financing ptins with different market rates that lenders may use t fund a fixed interest rate prduct. Usually the market rate is based n financing vehicles that have a similar length as the average life f the lan prduct fr example, if a lan prduct has an average life f 5 years, the market rate may be based n the 5-year US Treasury Bnd. Fixed interest rates are almst always higher than variable rates at the time the lan is riginated. Variable Interest Rates

2 When smene applies fr a variable rate lan, the interest rate is als usually determined at the time f apprval hwever, the interest rate will fluctuate ver time. Variable rates cnsist f tw cmpnents: An index (which is publicly available and nt cntrlled by the lender), plus a credit-based margin determined by the lender. Again, the applicants/c-applicants with the best credit scres wuld qualify fr the lwest margins. The starting rate n a variable rate lan is usually lwer than the rate n a fixed rate lan. Index and Margin The index rate will vary ver time based n ecnmic cnditins. The margin, hwever, is lcked in at the time f credit apprval, meaning it will nt change until the lan is paid ff. Fr example, if smene tk ut a lan with a variable rate f LIBOR + 5%, and LIBOR was at 3.58% at the time they tk ut the lan, then their variable rate wuld have been 8.58%. When the LIBOR rate changed t 1.82%, the variable rate then changed t 6.82%. The 5% margin remains cnstant thrughut; nly the LIBOR index changes based n market cnditins. Cmmn Variable Rate Indices Used fr Student Lans LIBOR: An interest rate at which banks can brrw funds frm ther banks. What it means: LIBOR stands fr Lndn Interbank Offered Rate. It's the rate f interest at which banks ffer t lend mney t ne anther in the whlesale mney markets in Lndn. It is a standard financial index used in U.S. capital markets and the rate is reprted every day in the Wall Street Jurnal. Hw it's used: LIBOR is an index that is used t set the cst f varius variable-rate lans. Lenders use such an index t adjust interest rates as ecnmic cnditins change. They then add a credit-based margin, which des nt vary, t the index t establish the interest rate charged n the lan. When this index ges up, interest rates n any lans tied t it als g up. It has traditinally been a reference figure fr crprate financial transactins but is increasingly used fr cnsumer lans as well. 2) WSJ Prime Rate: The prime interest rate, r prime lending rate, is largely determined by the federal funds rate, which is the vernight rate at which the federal reserve lends t banks. What it means: The initials WSJ stand fr the Wall Street Jurnal, which surveys large banks and publishes the cnsensus prime rate. The WSJ surveys the 30 largest banks, and when three-quarters f them (23) change, the WSJ changes its rate, effective n the day the Jurnal publishes the new rate. It's the mst widely quted measure f the prime rate, the rate at which banks will lend mney t their mst-favred custmers. The prime rate will mve up r dwn in lck step with changes by the Federal Reserve Bard.

3 Hw it's used: The prime rate is an imprtant index used by banks t set rates n many cnsumer lan prducts, such as credit cards r aut lans. If yu see that the prime rate has gne up, yur variable credit card rates will sn fllw. 2) Histrical Interest Rates Past 20 Years 3) Time Perid 1-Mnth LIBOR Prime Rate Ending Net Change Ending Net Change Sep 1990 Aug Sep 1991 Aug Sep 1992 Aug Sep 1993 Aug Sep 1994 Aug Sep 1995 Aug Sep 1996 Aug Sep 1997 Aug Sep 1998 Aug Sep 1999 Aug Sep 2000 Aug Sep 2001 Aug Sep 2002 Aug Sep 2003 Aug Sep 2004 Aug Sep 2005 Aug Sep 2006 Aug Sep 2007 Aug Sep 2008 Aug Sep 2009 Aug Sep 2010 Aug Average:

4 Over the last tw decades, variable rates have decreased slwly with slight temprary mvements in bth directins % % Primary Cnsumers Cncern: Payment Impact The primary reasn cnsumers are cncerned abut a variable rate is a fear f rising interest rates and lack f predictability, and the resulting ptential impact t their mnthly payment. It is imprtant fr cnsumers t understand these key pints: 1. While a variable rate can g up, it can als g dwn. 2. Over time, a custmer will see mvement in bth directins, and the net effect ver time is fairly small. 3. The impact n a custmer s mnthly payment is relatively mderate Example: Tw cnsumers tk ut a $10,000 lan in The first pted fr a fixed rate at 9.0% and the ther chse a variable rate f L+3.0% (8.73% at the time, assuming n runding up r dwn). Bth lans had a 10-year repayment perid. Here is what their payments wuld have lked like: Repayment Perid Year 1 Mnthly Payment Fixed Rate 9% Mnthly Payment Variable Rate Lan Variable L+3.0%: Changing every 12 mnths $ L=5.73% +3.0% = 8.73% Year 2 $ L=5.37% + 3.0% = 8.37% Year 3 $ L=6.63% + 3.0% = 9.63% Year 4 $ fr 120 mnths $ L=3.58% + 3.0% = 6.58% Year 5 $ L=1.82% + 3.0% = 4.82% Year 6 $ L=1.12% + 3.0% = 4.12% Year 7 $ L=1.65% + 3.0% = 4.65%

5 Year 8 $ L=3.69% + 3.0% = 6.69% Year 9 $ L=5.33% + 3.0% = 8.33% Year 10 $ L=5.50% + 3.0% = 8.50% Ttal Repaid: $15,201 $14,068 Average Rate: 7.04% The starting interest rate and payments were very similar fr bth custmers. While there were changes in the mnthly payment with the variable rate lan, these were nt dramatic the largest upward jump happened in year 3, when the mnthly payment increased by $5.63. Overall, the custmer chsing the variable rate lan saved $1,133 in ttal lan csts in an envirnment where rates mved nticeably in bth directins ver time. Keep in mind that histrical perfrmance is n guarantee f future perfrmance. It s als imprtant t nte that LIBOR is currently at histric lws s there is much mre rm t g up than dwn. Additinal Key Pints Stability and Familiarity Cncerns Fixed interest rates appeal t cnsumers wh place a high value n stability. The Federal Reserve annunced n January 25, 2012, that it wuld leave rates unchanged and des nt plan any changes until late Therefre, variable rates are likely t remain stable fr the next tw years. Many private student lans tday are based n the LIBOR rate. Many cnsumers are nt very familiar with this index but it is cmmnly used because it is clsely tied t the lender s cst f funding lans. Becming familiar with variable rates indices and histrical insights int changes ver time shuld help cnsumers becme mre cmfrtable with LIBOR-based lans. Ttal Cst Cncerns Whether a fixed rate lan is better fr an individual than a variable rate lan will depend n the interest rate envirnment when the lan is taken ut, the duratin f the lan, and the value the cnsumer places n predictability. 1 Althugh there are n guarantees, studies have fund that, ver time, the brrwer is likely t pay less interest verall with a variable rate lan versus a fixed rate lan. 1 Brrwers shuld strngly cnsider the amrtizatin perid f a lan. The lnger the amrtizatin perid f a lan, the greater the ptential impact f a change in interest rates. Many families view gap funding fr cllege educatin thrugh private lans as a shrt-term financing slutin, which means the ptential impact f a change in variable interest rates is mitigated by them paying ff the lans within a reasnable timeframe.

6 Schls already encurage graduating students t priritize paying dwn their private student lans ver their federal student lans in an effrt t reduce lans with higher cst ptential. When students priritize paying ff their lans, the highest-rate lan shuld be the primary fcus. Depending n the factrs cited abve (rate envirnment and duratin f lan) this is usually the case even if it is at a fixed interest rate. What is an APR? The Annual Percentage Rate (APR) is the ttal cst t the brrwer expressed as a single percentage number. It represents the actual yearly cst f brrwing ver the term f a lan, including fees r additinal csts assciated with the lan. Why is the APR lwer n a deferred lan and higher n a lan with immediate interest r principal and interest payments? When a lan is structured t pay the accruing interest immediately, a cnsumer realizes the full cst f brrwing upfrnt when making the payments, which cvers the accrued interest. Therefre, the APR is very clse t that f the interest rate. In the case f a deferred lan, the brrwer des nt make any payments during the interim; thus, the cst is deferred until repayment begins, which lwers the APR. Fees will increase the APR as they add t the ttal cst f brrwing. Befre making brrwing decisins f any kind, cnsumers shuld cnsider all available ptins, educate themselves n terminlgy and pricing elements they d nt fully understand, and carefully weigh their needs against the prduct ffer and ttal lan cst. When in dubt, it s always a gd idea t cnsult a financial advisr. 1) Surce: 2) Surce: 3) Surce: