Low starting rates of variable products sound good, but there’s no guarantee the rate won’t increase
Without a crystal ball, it’s increasingly difficult to know whether a fixed, variable or adjustable interest rate is the way to go in this changing economy.
Instead of guessing at what may happen to rates and picking one to fit the scenario (a fixed rate when interest rates are rising and a variable product when rates are dropping), look at all the variables and also consider your personal risk tolerance. As a rule, fixed rates are always higher than variable rates. They may be the safe choice in the long-term, though, if rates increase.
While nobody knows with absolute certainty, it would appear that we’re in a rising interest rate environment. Today’s fixed rates are roughly 2 percent higher than three to five years ago. This means that the person who opted for a fixed rate three to five years ago now has an interest rate that is lower than a person who choose the variable rate, at the same time. Reports indicate that the Federal Reserve may institute two or three additional rate hikes in 2019, leading most to believe that rates will continue trending up.
Interestingly, even as rates may move back to what can be called moderate or historically average rates, there’s a whole generation of borrowers who have not experienced average rates. It may require some education on both sides of the lending table to manage expectations. Borrowers who remember the interest rate highs of the late 1970s and early 1980s are nearing retirement. It’s difficult to define normal interest rates when rates in today’s market still remain historically low.
Unfortunately, it’s not an easy choice. Instead, consider all the variables and make an informed choice based on your situation.
Length of loan term
• Shorter loan terms make variable rates attractive. While variable rates have not risen significantly over any three- to five- year period in the past, it is possible for large rate increases to occur overnight.
• Longer-term loans often have a fixed rate as there is more time for rates to potentially rise during the life of the loan.
Variable rate terms
• Some variable rate products have a cap, meaning the rate cannot rise above a certain level. Understand loan terms and compare the rate cap with the fixed-rate option.
• Will payments increase as interest rates rise? If the payment is not re-amortized and the payment remains the same for the life of the loan, less is allocated to principal each payment and there will be an outstanding balance at the end of the loan.
• Know what the variable rate is tied to. Variable rates are tied to LIBOR, Fed Funds Target rate and Prime indexes. With some research, you can make an educated guess at the probability of rate changes.
Decide your tolerance for risk
Prefer a payment that remains the same for the life of the loan, or can you accommodate payments that fluctuate over time as rates change?
If you choose a fixed rate and rates drop, you can refinance your loan at a lower rate. This will involve fees, though, so ensure the new rate is low enough to offset refinancing costs so you come out ahead.
The best advice is to ensure you can afford what you are buying, feel comfortable with your personal risk tolerance and be sure you fully understand the terms of the loan and interest rate you choose.
Jody Almand is the lead senior credit analyst for Farm Credit of Western Arkansas.