Fixed APRs vs Variable APRs

APR is a way to measure how much interest you’re going to pay when taking out credit, such as a loan, mortgage, or credit card. Specifically, APR refers to the product’s stated interest rate (aka “nominal rate”) plus any other fees or costs.

For example, the nominal rate advertised for a mortgage might be 5%. But that doesn’t include the lender’s financing charges, such as origination fees, maintenance fees, or closing costs. Therefore, the interest rate to look for is the APR – the actual rate you’ll pay over the course of a year, including any financing charges. Lenders will usually tell you the APR of a loan, mortgage, or credit card. However, you can calculate APR yourself, though it becomes more complicated if interest is compounded.

When comparing lending products, remember that additional fees vary from lender to lender and even from product to product. So even if the nominal rates for various credit offerings are the same, the actual amount you’ll pay can differ.

Don’t confuse APR with annual percentage yield, or APY. That’s the actual amount of interest you’ll receive on savings products. Here’s an explanation of APR and APY and how they relate to interest rates.

A fixed APR is one that’s set for the entire duration of a loan. It’s not linked to a benchmark interest rate, such as the prime rate or the Secured Overnight Financing Rate (SOFR), so it won’t fluctuate with market interest rates or Federal Reserve policy decisions. Rather, the lender’s funding cost at the time the loan determines the APR for the life of the loan.

Mortgages, auto loans, and installment loans – including federal student loans – typically have fixed APRs. Since the interest you’ll pay won’t fluctuate, your lender may provide you with a schedule of payments for the whole period of the loan.

Sometimes a loan starts out with a fixed APR but changes to a variable APR when certain conditions are met. For example, an adjustable-rate mortgage (ARM) offers a “teaser rate” that is fixed for a specified number of years but then becomes variable. Some credit cards offer a fixed 0% APR as an introductory rate for the first year or so of your being a card member – but these cards may revert sooner to a variable APR if you are late with a payment.

It’s wise to check the terms and conditions of any fixed APR loan, credit card, or mortgage, as they will tell you whether the APR can change and, if so, under what circumstances.

A variable APR loan is linked to a benchmark rate, such as the prime rate or SOFR. These benchmark rates fluctuate with market conditions or Federal Reserve interest rate policy decisions, so the APR on the loan can change from day to day, depending on how the benchmark rate is moving.

A variable APR is often quoted as a margin over the benchmark rate. For example, a loan with a variable APR might be quoted as “prime + 3%.” In this case, if the prime rate is 5%, the variable APR is 8%. The margin on a variable APR loan doesn’t usually vary. However, it’s wise to check the terms and conditions of the loan, as there could be clauses allowing the lender to increase the margin under some circumstances.

Credit cards and adjustable-rate mortgages typically have variable APRs. You can also find variable APRs on private student loans, as well as on personal and home equity lines of credit.

Prices for variable APR loans may appear to be more attractive than those for fixed APR loans, but if interest rates rise, you could end up paying more than if you had chosen a fixed rate loan.

For example, suppose you took out an adjustable-rate mortgage on July 26, 2022, with a margin of 2.75% over SOFR. At the start of the loan, SOFR was 1.53%,¹ meaning your variable APR was 4.28%. But by August 26, 2022, SOFR had risen to 2.28% and your APR to 5.03%, an increase of 0.75%. This doesn’t sound like much, but it actually means your monthly payment has gone up by about 17.5%.

In contrast, had you taken out a mortgage with a fixed APR of 5% on July 26, 2022, you’d still be paying that rate at the end of August 2022. So, your monthly payments would work out to be lower than payments on the variable-rate loan.

Because the amount you pay can vary, a variable APR loan can wreak havoc with your household budget. Some people may prefer a fixed APR loan because of the certainty it grants, even if it means they could end up paying more. As a result, many homeowners opt for a 30-year fixed mortgage to ensure that the cost of owning their own home will remain constant over the long term, regardless of economic conditions.

However, if interest rates are falling, fixed APR loans can become expensive. Variable APRs fall in line with benchmark rates, but fixed APRs don’t. This means, if you had taken out a fixed APR loan at 5% in August 2019, by August 2020 your payments would have been nearly twice as much as those on a variable APR loan with a margin of 2.5% over SOFR, because SOFR fell from 2.19% in August 2019 to 0.09% by August 2020.²

If you have a fixed APR loan with a higher interest rate and notice interest rates are falling, you may be able to refinance the loan at a lower interest rate. For more on refinancing, read “Guidelines for When and How to Refinance a Home Loan” or “Can I Refinance My Student Loan?”