Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Fixed- vs. variable-rate auto loans

Dear Dr. Don,
What is better for a new vehicle loan -- a fixed-rate or a lower variable-rate? Also, what exactly are the differences between variable and fixed interest rates?
Aaron Auto

Dear Aaron,
When deciding between a variable-rate loan and a fixed-rate loan, the variable-rate loan will almost always have a lower interest rate initially than a fixed-rate loan. The lender can offer a lower rate on the variable-rate loan because it doesn't face any interest rate risk. You face the risk.

Variable-rate loans are priced using a base rate plus a spread. That base rate can be The Wall Street Journal's prime rate, the London Interbank Offered Rate, LIBOR, or whatever index the lender chooses to price its variable-rate product. You can track these rates using Bankrate's Rate Watch feature. Variable-rate auto loans aren't widely available. A good place to start shopping for one is with your local credit union.

If a variable-rate loan is priced at prime plus a quarter percent, then the loan has a current interest rate of 4.5 percent. Your loan rate changes with changes in the prime rate. Some variable-rate loans have floors or caps denoting the minimum and maximum interest rate changes. Variable-rate loans with both a cap and a floor are said to have a collar.

If we assume that the other loan terms are the same, lower interest rates mean lower payments and lower total interest expense. That frees up money in your monthly budget that you could then use to make additional principal payments on your auto loan.

Interest rates can and do bounce around a lot. There's not a lot of room for short-term rates to head much lower, so it's likely that you would face rising rates over the variable rate loan's term.

With a fixed-rate loan, the lender offers the borrower an interest rate that is constant over the life of the loan. The lender shoulders the interest rate risk. It can make sense to refinance if interest rates go lower, but the lender can't raise your rate if interest rates go higher. You can shop fixed-rate loans in your market on Bankrate.

Look at the difference in rates between the two loans and the difference in monthly car payments. The closer the rates, the less protection you have against rising interest rates. If there's a big enough spread between the two rates that you're willing to take on the interest rate risk inherent in a variable-rate loan, then consider making additional principal payments to bring down your loan balance while the variable rate is lower. Make sure there's no prepayment penalty involved in making those additional principal payments.