It’s no secret that acquiring debt can cause grief and anxiety. But whether it's for an unplanned financial emergency, an upcoming renovation or a needed major purchase, there are some situations when taking out a personal loan makes sense.
A personal loan can be easier to apply for in comparison to other types of financing such as credit cards, or a personal line of credit from your bank. There are also no restrictions in how you spend a personal loan. However, borrowing money from a lender or bank means you’re legally committed to paying the money back within a certain timeframe.
So when applying, simply guessing if your budget can afford the timely payments is a bad idea. First, you need to understand how interest rates will affect your payments, and you basically have two ways to go — fixed rates or variable rates.
Fixed-rate loan: the “set it and forget it” choice
With a fixed-rate loan, the loan rate and payment you make each month will stay constant for the term of your loan, no matter how much the market fluctuates.
This means you'll know the exact amount you'll be required to pay towards the principal (the amount initially borrowed under the loan) and interest (the amount paid on whatever you borrowed) on each scheduled payment throughout the term you select.
Consistent monthly payments ease budgeting anxiety, offer much more stability and may be more attractive if you intend on paying off the loan over a longer term. The downside? Expect to pay a premium for this stability as the interest rate on fixed loans is often higher than variable loans.
Also, since you are locked in, you won't be able to take advantage of lower rates if interest rates happen to drop during the term of your loan. A lower rate can ensure more of your payments go towards the principal and less to interest.
Variable-rate loan: the “let’s see what happens” choice
With a variable-rate loan, the interest rate will fluctuate depending on the prime lending rate — the rate at which financial institutions lend to their best customers. In this case, the amount you will be required to pay each month will vary.
The amount paid towards your principal and your interest will change month-to-month. Cautious buyers often choose a fixed loan because it means they can plan for the length of their loan term without any surprises.
Variable rates are more unpredictable, making it more difficult to budget, but could work out to be cheaper in the long run as long as you can handle a bit of risk and uncertainty. If you plan to pay the loan off in a short period of time, or you’re confident that interest rates will decrease, then you’ll likely be rewarded by going variable.
Should I get a fixed loan or a variable loan?
How much of a loan should you take out? How long of a term should you choose? Should you go with a fixed rate or variable rate? What’s the best option for you? Well, this all depends on your personal circumstances and ultimately how much you can realistically afford every month.
Evaluate your overall financial situation and your cash flow to see if you can work loan payments into your budget. Think of the difference, or spread, between the payments you’ll make with a fixed rate versus the payments you’ll make with a variable rate.
Though a variable rate is unpredictable, you can estimate by looking at past market trends, talking to a financial advisor or even using an online loan comparison site.
Over the last several years, interest rates have been at historical lows. While opinions vary as to precisely when that may change, we’re already starting to see some slight shifts in the market. The Bank of Canada raised interest rates by 25 basis points three times since last July, making the current benchmark rate 1.25% – the highest since 2009. Markets are predicting there's roughly a 70% chance the central bank could hike rates again as early as May.
No matter which route you take, it's crucial you evaluate the impact of an increasing interest rate on your loan costs – a stress test, if you will. As well, with such a wide variety of lenders to choose from, it’s important to do your research on just who is offering what to prospective clients.
