Fixed vs Variable Interest Rates

Introduction

Interest rates affect both sides of everyday finance. If you are saving money, the rate helps determine how much interest you can earn. If you are borrowing, it helps determine how much interest you may have to pay. But the percentage itself is only part of the picture — it also matters whether that rate is fixed or able to change.

A fixed interest rate remains at an agreed level for a specified period. A variable interest rate can change, which means the interest you earn or pay can also change. If you are new to how rates work generally, What Is Interest? explains the underlying principles before looking at the distinction between fixed and variable rates.

The difference matters because it affects certainty. A fixed rate makes it easier to know the rate that will apply during the fixed period, while a variable rate introduces the possibility of both increases and decreases. That can affect savings returns, borrowing costs and the value of money over time.

Calfiny’s Interest Rate Calculator can help you explore the relationship between a starting amount, final amount, time period and annual interest rate. Later in this guide, we’ll also look at how changing rates can affect longer-term outcomes.

What Is a Fixed Interest Rate?

A fixed interest rate is a rate that remains unchanged for an agreed period. If a financial product has a fixed rate of 4% for two years, for example, that 4% rate will continue to apply throughout the fixed period, provided the terms of the product are met.

For savings, fixing the rate can make the return more predictable. You know the interest rate that will apply even if rates available elsewhere rise or fall during the fixed term. The trade-off is that fixed-rate savings products can place restrictions on withdrawals or require you to leave the money untouched for a specified period.

Fixed rates are also common with borrowing. A fixed-rate loan or mortgage can keep the applicable interest rate unchanged for a defined period, making borrowing costs more predictable during that time. The rate does not necessarily remain fixed for the entire life of the borrowing: once the fixed period ends, a different rate may apply.

The main advantage of a fixed rate is therefore certainty. You are protected from rate increases during the fixed period, but you may also miss out if wider interest rates move in your favour. Whether that trade-off is worthwhile depends on the product, its terms and what happens to rates during the fixed period.

What Is a Variable Interest Rate?

A variable interest rate is a rate that can change over time rather than remaining fixed for an agreed period. This means the amount of interest you earn on savings or pay on borrowing can increase or decrease while you hold the product.

Variable rates can change for different reasons. Some products have rates that track or are linked to an external benchmark, while others allow the provider to change the rate in accordance with the product’s terms. As a result, it is important to understand not only the rate being offered today but also how and when that rate can change.

For savers, a variable rate can be beneficial if rates rise because the return on the account may increase. The opposite is also possible: if the rate falls, the amount of interest earned can decrease. Variable-rate savings accounts may offer greater access to your money than some fixed-rate products, although this depends on the individual account.

With borrowing, changes can work in the opposite direction financially. A falling variable rate may reduce the interest cost, while a rising rate can make borrowing more expensive. This uncertainty is the defining feature of a variable rate: you may benefit from favourable rate movements, but you also accept the risk that the rate can move against you.

Why Do Variable Interest Rates Change?

Variable interest rates can change because the financial conditions behind them can change. Some variable-rate products are linked directly to a benchmark rate, while others are set by the bank, lender or savings provider and can be adjusted under the terms of the product.

One important influence in the UK is the Bank of England’s Bank Rate. Changes in Bank Rate can affect the rates available across savings and borrowing, although providers do not necessarily change every product by the same amount or at exactly the same time.

Some products make the relationship more explicit. A tracker mortgage, for example, may be set at a particular margin above Bank Rate. If the benchmark moves, the rate charged on the mortgage can move with it according to the product terms. Other variable rates may be determined more broadly by the provider rather than tracking a benchmark directly.

This is why understanding how a rate is determined can be just as important as knowing its current percentage. How Banks Calculate Interest looks more closely at how rates and balances translate into the interest actually earned or charged.

How Can Changing Interest Rates Affect Your Money?

When an interest rate changes, the effect depends partly on whether you are earning interest or paying it. For a saver, a higher rate can increase the amount of interest earned, while a lower rate can reduce it. For a borrower with variable-rate debt, the relationship is generally reversed: a higher rate can increase the cost of borrowing, while a lower rate can reduce it.

The effect can become more significant when larger balances or longer periods are involved. Even a relatively small change in the annual rate can produce a different financial outcome when that rate continues to apply over time.

This is one reason fixed and variable rates involve different types of uncertainty. With a fixed rate, you can model the fixed period using a known rate. With a variable rate, any longer-term calculation has to make assumptions about what may happen to the rate in the future, and the actual outcome may be different.

You can explore this relationship with Calfiny’s Future Value Calculator. Try keeping the starting amount and time period unchanged while altering the assumed interest rate to see how different rates can affect the estimated future value.

When Might a Fixed Interest Rate Be Useful?

A fixed interest rate can be useful when certainty is more important to you than benefiting from future rate movements. Because the rate is known for the fixed period, it is easier to understand the rate that will apply without having to account for changes along the way.

For savings, this may appeal if you are comfortable leaving money in an account for a defined period in return for knowing the interest rate in advance. The disadvantage is that if savings rates rise elsewhere, your existing fixed rate normally remains unchanged until the fixed term ends.

For borrowing, a fixed rate can make costs more predictable during the fixed period. This can be particularly useful when budgeting because changes in wider interest rates will not alter the fixed rate during that time. However, the product may have restrictions or charges associated with changing or leaving the agreement early.

A fixed rate is therefore not automatically the better choice. Its main benefit is predictability, and that needs to be weighed against the product’s conditions, flexibility and what could happen to interest rates while you are fixed.

When Might a Variable Interest Rate Be Useful?

A variable interest rate may be useful when you are comfortable accepting uncertainty about future rates in exchange for the possibility of benefiting if rates move in your favour. Unlike a fixed rate, you are not locked into the same percentage for a defined fixed period.

For savings, a variable-rate account may allow your return to increase if the provider raises its rate. Some variable-rate savings products can also offer easier access to your money than fixed-term alternatives, although access conditions vary between accounts and should always be checked.

For borrowing, a variable rate can become less expensive if the applicable rate falls. However, the opposite is equally important: if the rate rises, the cost of borrowing can increase. This can make future costs less predictable than they would be during a fixed-rate period.

The decision therefore involves more than trying to predict whether interest rates will rise or fall. The product’s terms, your need for flexibility and how comfortably you could manage an unfavourable rate change can all matter when comparing fixed and variable options.

Is a Fixed or Variable Interest Rate Better?

Neither fixed nor variable interest rates are automatically better. The more useful question is which type of rate better suits the financial product you are considering and the level of uncertainty you are comfortable accepting.

A fixed rate can be attractive when predictability matters. You know the rate that will apply throughout the fixed period and can make decisions without worrying about that rate changing. The trade-off is that you normally will not benefit if wider rates subsequently move in your favour.

A variable rate provides less certainty but gives you exposure to future rate movements. Those movements could work in your favour or against you. For savers, a rate increase can mean earning more interest; for borrowers, a rate increase can mean paying more.

It is also important to compare the actual terms of the products rather than making a decision based solely on whether the rate is fixed or variable. The rate itself, how long any fixed period lasts, fees, access restrictions and what happens when a fixed period ends can all affect the overall outcome.

When comparing the percentages shown on savings and borrowing products, it can also help to understand the different ways rates are presented. AER vs APR Explained covers why these annual percentage measures serve different purposes and how to interpret them.