Taking out a loan obligates you to pay back the amount you borrow, but lenders also charge interest so that they can make a profit. The interest rate you pay depends on a variety factors, such as your credit score, the current interest rates in the economy and the terms and conditions of your loan. Loans generally fall into two basic categories when it comes to how your interest rate works: fixed-rate loans and adjustable-rate loans.
A fixed-rate loan has an interest rate that remains the same over the life of the loan. When you take out a fixed-rate loan, you are locked in at a specific interest rate and you pay that amount regardless of what happens to interest rates in the overall economy. Because the interest rate on a fixed-rate loan doesn't change, you know in advance how much the loan will cost you and what your monthly payments will be.
An adjustable-rate loan -- also known as a variable-rate loan -- has an interest that can change over time. When you take out an adjustable-rate loan, the lender alters the interest rate on the loan to reflect current interest rates in the economy, so the rate can go up or down. Some loans begin with a fixed interest rate that lasts for a few years, after which the rate is adjustable for the remainder of the life of the loan.
Adjustable-rate loans are generally considered riskier than fixed-rate loans because they are unpredictable. You might start out with a low rate on an adjustable-rate loan, but a rise in interest rates over time could greatly increase the cost of your loan. With a fixed-rate loan, increases in interest rates across the economy don't affect you. On the other hand, if interest rates fall, an adjustable-rate loan could end up saving you money.
Refinancing is a process where you let a new lender pay off a loan and give you a new one with different terms and conditions. Loan refinancing can allow you to switch from an adjustable-rate loan to a fixed-rate or vice versa. Refinancing can also let you to reduce your interest rate. For example, if you have a fixed-rate loan with a 6 percent rate and interest rates in the economy have fallen to 4 percent, you could refinance to a new fixed-rate loan to lock in at the lower 4 percent rate.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.