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Fixed vs. variable interest rates: Which is best for how you borrow and save money?

Anna Serio-Ali
Fixed vs. variable interest rates: What’s the difference — and which is best? (Andrii Yalanskyi via Getty Images)

When you apply for a bank account or financing, the interest rate you receive can give you a sense of how much you’ll earn in returns — or pay to borrow money. However, not all interest rates work the same. Two of the main types of interest rates you’ll come across are fixed rates and variable rates. The main difference is that fixed rates stay the same over time while variable rates can change based on market conditions.

In many cases, the choice between fixed and variable rates will be a choice between products, rather than providers. For example, it’s difficult to find a personal loan with a variable rate or high-yield savings account with a fixed rate. But with some products like home or car loans, you can choose the type of rate that works best for you. And which works best for you largely depends on the state of the economy and how long you plan on using that product.

With a fixed-rate product, such as a loan or bank account, the interest rate you sign up for is the interest rate you’ll earn for the life of the product. For example, most certificates of deposit earn the same rate of return every month until they reach maturity — even if the Federal Reserve raises or lowers interest rates.

The main benefit of using a fixed-rate product is predictability: You’ll know ahead of time exactly how much you’ll earn on a traditional CD. The same is true for loans — you’ll know the monthly and total cost of a fixed-rate loan before you sign the closing documents.

Generally, fixed rates offer higher savings on interest-earning products when the federal funds rate — or Fed rate — is high. This is particularly true when the Federal Reserve is signaling that they might lower interest rates in the future. By opening a fixed-rate account in a high-rate environment, you’re able to lock in earnings you could otherwise lose if you signed up for a variable-rate account.

The opposite is true for products that require you to pay interest, like loans and credit cards. Fixed rates are beneficial when you need to borrow money and the Fed rate is low. This is particularly true when it comes to long-term financing, since a fixed rate also offers protection against a fluctuating market. After all, it’s difficult to predict how the market will change over the next 10 or 20 years.

Financial products that typically come with fixed interest rates include:

Dig deeper: High-yield savings vs. CDs: What to know while rates are high

Some savings bonds have fixed interest rates, though they’re subject to change after long periods of time. For example, Series EE Savings Bonds currently earn a 2.70% interest rate, which is subject to change after 20 years. Series I Savings Bonds are fixed at 4.28%, though this rate may change every six months based on the inflation rate.

Treasury notes and Treasury bills also technically come with fixed rates, though how much you earn depends on the price of the security when you sell it. However, the Treasury Department sometimes guarantees that you’ll earn money. For example, you’ll earn no less than 0.125% in interest on a Treasury note.

Variable rates work by rising or falling in reaction to financial markets. Typically, they’re tied to a benchmark rate, such as the Wall Street Journal Prime Rate and the Secured Overnight Financing Rate. Benchmark rates are based on the lowest interest rate banks are willing to offer to a borrower, and they’re highly influenced by the Fed rate. This is especially true for the WSJ Prime rate, which typically changes a few days after a Federal Reserve meeting at which the Fed announces a rate adjustment.

With financing, variable rates typically comprise a low, fixed interest rate — called a margin rate — and a benchmark rate. So if you take out a loan with a 4% margin rate plus the prime rate, you’re essentially guaranteeing that you’ll pay at least 4% in interest. But in reality, you’ll likely pay at least 7.25% in interest, since the prime rate hasn’t dipped below 3.25% in the past 50 years.

The annual percentange yield (APY) on bank accounts is a little less predictable than the annual percentage rate (APR) on a bank's lending products, but the two measurements tend to rise and fall in tandem. That’s because banks use APYs to draw in customers to deposit funds, which the banks use to fund loans and earn interest. If banks are earning more interest from consumers, they can afford to entice more people to open bank accounts with higher APYs.

In many cases, lenders set caps on variable-rate products. This was designed to protect consumer borrowers from the kind of runaway interest the country saw during the 1980s.

There are no federal interest rate protections for all consumers, though the Military Lending Act prevents lenders from charging more than 36% in interest and fees to active duty service members and their spouses. Many states also cap interest rates at 36% or lower for consumer loans.

Lenders can also offer caps on variable rates in addition to government protections. This is common particularly with private student loans and home loan products. In fact, adjustable-rate mortgages come with several rate caps to protect consumers during periodic rate adjustments in addition to the life of the loan.

🔍 Why do interest rates change?

Interest rate changes are among the only means that the federal government has to control the U.S. economy. Typically, the Federal Reserve raises interest rates to help lower prices during a time of inflation, and lowers rates during an economic downturn or recession.

The logic here ties back to supply and demand: Higher interest rates make borrowing more expensive, which in turn keeps some people from making expensive purchases that require financing — like a home or a car. The decreased demand for these products should, in theory, lower the prices and cool inflation.

When the Federal Reserve lowers interest rates, the intention is to make it easier for folks to make large purchases. This helps funnel money into businesses, stimulating economic growth.

Unfortunately for borrowers, a study published by the Federal Reserve found that it takes a lot longer to cool the economy than it does to heat it up. That’s because other factors, such as a nationwide housing shortage, can work against the high Fed rate by keeping prices high.

Variable rates are often a better option for interest-earning products when the Fed rate is low. That’s because you’ll have a chance of earning more interest in the future if interest rates rise.

The opposite is true for financing products that require you to pay interest. Variable-rate financing products are more beneficial when rates are high and appear to be coming down. If it’s expected that rates could potentially increase even more, fixed-rate products may be a safer choice.

Here’s a list of the types of products that can come with variable interest rates:

Dig deeper: High-yield savings vs. money market account: Which is best for growing your savings?

Some investment products earn interest that works similarly to a variable rate. For example, floating-rate notes, or FRNs, have rates based on the 13-week Treasury bill, plus a spread — similar to a margin rate.

Treasury Inflation Protected Securities, or TIPS, also pay out interest that functionally works like a variable rate. Technically, the interest rate on a TIPS is fixed at no less than 0.125%, but the principal can increase or decrease depending on the market. So while the interest rate remains the same, the interest payout you receive can change depending on the principal.

Often you won’t have a choice between fixed and variable rates — even if the product you need would benefit from one more than the other. In that case, you might want to consider swapping products when the market changes. With interest-earning products, this typically involves moving money among bank deposit or savings accounts. With lending, this typically involves refinancing.

Consider this example of how to keep yields high on a savings account. Say you transfer your savings to a high-yield savings account with a variable rate after the Federal Reserve announced it’s raising the Fed rate to cool inflation. The trickle of returns you were accustomed to when rates were low suddenly turn into a flood.

But recently, the Federal Reserve begins signaling it wants to lower rates soon. To keep those high returns coming, you might decide to put some of that money into a fixed-rate certificate of deposit.

Here’s an example of how to keep rates low on financing. Say you take out a fixed-rate personal loan to pay down high-interest credit card debt when the Fed rate is at an all-time high. Since credit card rates are generally higher than personal loan rates by default, the slight interest savings are worth it.

But then, a year into paying off your loan, the Federal Reserve lowers rates. Suddenly, you’re left with a 16% APR when you could qualify for a 9% APR if you took out a loan today. You can still take advantage of the lower-rate environment by taking out a new personal loan at that 9% APR to pay off the 16% APR loan.

Fixed and variable rates aren’t the only type of interest rates to keep in mind when you’re shopping around for a financial product.

Here are some other types of interest you might run into:

  • Tiered interest. Tiered interest offers different series of APY ranges depending on how much you deposit into a bank account — typically the more you deposit, the higher the rate of return. This is most common on CDs and money market accounts.

  • Compound interest. Compounding is often described as earning interest on your interest. It’s a way of earning interest on both your initial account principal and any interest you’ve earned along the way. You’ll find compound interest on most types of deposit and savings accounts.

  • Simple interest. Simple interest is the inverse of compound interest in that it separates your principal from any interest. It uses only your principal — with no compounding. This type of interest is common on financing products like loans.

Anna Serio-Ali is a trusted lending expert who specializes in consumer and business financing. A former certified commercial loan officer, Anna's written and edited more than a thousand articles to help Americans strengthen their financial literacy. Her expertise and analysis on personal, student, business and car loans has been featured in Business Insider, CNBC, Nasdaq and ValueWalk, among other publications, and she earned an Expert Contributor in Finance badge from review site Best Company in 2020 for her work at Finder.

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