A question people often have regarding loans is whether to choose a loan with a fixed or variable interest rate.
Recently, in Denmark (and I assume in other countries too), people are increasingly choosing loans with fixed interest rates over variable interest rates. The argument is often that the interest rates currently are historically low, thus they can only increase in the future.
However, you shouldn’t follow that argument, because as everyone in the personal finance sphere knows nobody can predict the future!
So which loan should you choose then? I’ll tell you what I think.
You should only get a loan if you really need it
If you follow this blog, you’ll know that I don’t like loans/debt at all.
In fact, I don’t think there are many good excuses to get a loan. I only think you should get a student loan for education (if you expect it will pay itself off) and a mortgage for buying a house (if you can’t get in the market with your current savings).
If you decide to get a loan, you’ll have to decide between a variable or a fixed interest rate loan. The most important part here is to not focus on speculation as to where the interest rate will go in the future. You should instead focus on your risk willingness, life situation and financial strength.
The consideration between choosing a loan with a variable or fixed interest rate becomes even more important the longer the duration of the loan is.
When you should choose a loan with a variable interest rate
If you have a variable interest loan, you will pay less interest at the point in time you take the loan. During the loan duration, you’ll either pay more, the same or less in interest depending on how the market develops.
The important lesson here is not to try to guess which direction the interest rates will go, because nobody knows.
You should choose a loan with a variable interest rate if you don’t mind the risk. You should choose a loan with a variable interest rate if you:
- Have a high income (i. e. the interest payments do not make up a large part of your disposable income – I would say maximum 10-20%)
- Have a high net worth (i.e. money in the bank to cover for potential interest rate increases)
- Have a high job security
- Have a stable life situation (e.g. not expecting more kids or dramatic changes to your life)
- Have a high degree of certainty regarding your income in the future
- Have good insurances against other shocks to your finances (e.g. health, unemployment)
The good thing about a loan with a variable interest rate is that you will not pay a premium for your loan. The fixed interest rate loans act as an insurance towards future interest rate increases, and because the banks provide that insurance, they will usually charge more for this by charging higher interest rates.
Of course, this does not hold in all cases, but if you want to “save” on that insurance, I believe you should choose a loan with a variable interest rate if you can check off most of the above criteria.
When you should choose a loan with a fixed interest rate
In general, you should choose a loan with a fixed interest rate if most of the above criteria do not apply to you.
If you are risk averse, have an uncertain financial future and expect that your life situation will change in the future during the duration of the loan, you should take a fixed interest rate loan as a rule of thumb.
If you use the fixed interest rate loan to buy a house, it will both act as an insurance towards higher interest rates, but also towards declining housing prices due to increased interest rates.
An important thing to keep in mind here is that if you cannot afford a fixed interest rate loan it shouldn’t be an excuse to take a variable interest rate loan, and you probably shouldn’t take a loan at all because the variable interest rate loan might turn out even more expensive in the long run.
I recently purchased a house. So which loan did I choose?
I chose a fixed interest rate loan because I am risk averse by nature (I want to be able to sleep at night and not check interest rates all the time), I expect not to get a full-time income in the future when I retire early (I want to know exactly what I will be spending in the future), and we expect to have kids within the next couple of years, which will change our financial situation quite a bit.
Your turn: Do you have any fixed or variable interest rate loans? Why?