What Is a Variable Interest Rate?

While applying for a credit card or a new loan, it may be easy to assume that the quoted interest rate will remain constant. However, this is not always the case. Certain financial products are offered with variable interest rates, indicating that the interest charged on what you have borrowed is subject to change.

Variable interest rates fluctuate over the life of the loan because they are derived from an index or underlying benchmark interest rate that changes regularly. As a result, your monthly interest payment can also go up or down.

Although having a loan with a variable interest is a financial risk, it can represent a superior option to a fixed interest rate loan in some situations.

Read on to understand variable interest rates, how they are determined, the pros and cons, and how they differ from fixed interest rates.

How do variable interest rates work?

Variable interest rates fluctuate over time, meaning your loan payments can change intermittently based on market conditions. Such varying rates are common on credit cards and lines of credit on home equity. Variable rates are also typical on student and mortgage loans (adjustable-rate mortgages).

The rate moves in conjunction with the rest of the market or the index on which it is based. The underlying benchmark interest rate depends on the type of security or loan but is usually linked to the London Interbank Offered Rate (LIBOR) or the federal funds rate.

Benchmarks such as the prime rate in the country also affect variable interest rates. Financial institutions usually charge consumers a spread over the benchmark rate, which depends on numerous factors like the consumer’s credit score and asset type. Hence, these institutions usually advertise the variable rate as the “LIBOR plus 250 basis points” (+2.5%).

You can find these interest rates in mortgages, credit cards, personal loans, derivatives, and corporate bonds.

How to find loan rate info

The rate is anchored to a specific financial index used as the base rate by lenders. This index is listed on the credit card member agreement or your loan documents. The most common indexes are:

The Cost of Funds Index (COFI)
The one-year constant-maturity treasury securities (CMT)
The London Interbank Offered Rate (LIBOR)
The Wall St. Journal Prime Rate

Your monthly payment and overall repayment costs change as the index moves up or down. For instance, if you take a 30-year fixed-rate $200,000 loan with an interest rate of 3.5%, your monthly payment comes to $898.09, and your total interest costs come to $123,311.97.

The costs would be different if you took out a 30-year 5/1 adjustable-rate mortgage (ARM). The 5/1 ARM is a five-year mortgage with a fixed interest rate. After five years, the lender changes the interest rate based on the index of choice.

Variable-rate loans usually have a lower starting interest rate than fixed-rate alternatives. This is because variable rates are less risky for lenders since the rate changes with the prevailing conditions.

Therefore, if you took a 30-year 5/1 ARM at a starting rate of 3.25%, fixed for five years, adjusted by one percentage point after those five years, and subsequently adjusted by 0.5 percentage points five times throughout the loan, your initial monthly payment is $870.41. However, your monthly payment would reach $1,342.32. As a result, your total payment would reach $235,061.37. Therefore, this specific variable rate loan costs more than the equivalent fixed-rate loan.

How often does the rate change?

The change depends on your agreement’s specific terms and the index that your lender utilizes as a benchmark. For example, credit card interest rates are normally anchored to the Wall St. Journal’s US Prime Rate. The frequency of rate changes that impact you depends on several factors:

Variable-rate student loans usually change periodically.
Variable-rate credit cards change as the Federal Reserve changes the federal funds rate, which happens many times a year.
Adjustable-rate mortgages typically stay constant for the first three to five years, after which they change periodically.

The Truth in Lending Act ensures that you receive all the necessary information about your interest rates before finalizing the loan. This forces lenders to disclose the APR and whether it’s variable or fixed. However, they don’t have to inform you when the variable rate has changed, though some do.

Financial institutions will notify you before each rate change occurs for certain loans. For example, for an adjustable-rate mortgage, your lender has to give you at least seven months’ notice before the first increase in your mortgage payment. After this, they will notify you two to four months before each change.

What are the types of variable interest rates?

You can get a variable interest rate on a mortgage, student loan, credit card, or home equity line of credit.

An adjustable-rate mortgage has a unique feature where it locks your starting rate in for a set amount of time, after which it institutes a variable interest rate. On the other hand, the interest rate and monthly payments can change right from the offset for credit cards and private student loans and be adjusted as frequently as every month.

Pros and cons

Variable interest rates have several advantages and disadvantages that you should consider before finalizing a loan or credit card application.

The significant advantage of variable interest rates is that starting rates are typically lower to entice borrowers. This reduces the initial burden of the loan and can be helpful in cases when you don’t anticipate having the funds for monthly repayments initially.

In addition, since the loan amount is more affordable in the short term, you are more likely to get approved for a loan even if you have a low income.

More importantly, variable rates bring the possibility that you can have even lower interest rates, further lowering monthly repayments and making the entire process cheaper.

The variable nature of the rate is, however, a double-edged sword. There is always the possibility that your monthly payment will change drastically, making it difficult to predict how much you will pay in interest. If the variable rate increases, you will have to pay more every month.

Such interest rates impact your capacity to repay your loans in sum if rate increases make the payments unaffordable. Therefore, if you are considering a loan with a variable rate, you should carefully go over the documents to determine how often and how much the rates can adjust. Then, ensure that you can afford the most expensive payment under your loan terms.

What is the difference between variable and fixed interest rates?

There are many notable differences between variable and fixed interest rates. The obvious is that fixed interest rates stay the same throughout the loan or contract. They also usually have a higher starting interest rate. Fixed interest rates offer more certainty about the total repayment and each monthly installment, which can help with planning as the total loan repayment cost is known upfront.

What are the downsides of variable interest rate loans?

While the chance of interest rate changes means that there is always the possibility that your lender will lower the interest rate on your loan, the possibility exists that the interest on your loan keeps growing.

For this reason, there is no way of knowing how much interest you will have to pay in the future under a variable rate contract. As a result, you might not have enough cash flow to fulfill monthly payments as interest could increase beyond your capacity.

The good news is that variable interest rates can go down; they are likely to decline while the economy is struggling or going through a recession. This decline is because the Federal Reserve usually lowers interest rates in such times to stimulate business development and job creation, which lowers borrowing costs on the loans taken on a variable interest rate.

You can always convert your variable rate contract to a fixed rate. All you have to do is pay the associated fee. However, it is uncommon to see contract changes from fixed to variable rates.

When is a variable rate ideal?

Variable interest rates carry their fair share of risk. The possibility of increasing monthly debt makes budgeting increasingly tricky. However, a variable rate could be ideal for you in certain situations.

You can avoid paying interest on your credit card purchases as long as you pay off your dues at the end of every month or during the 0% interest introductory period. If you fail to do so, only pay the minimum due, or carry a balance on a credit card with a variable rate, you will probably have to pay more interest than expected.

Indexing and interest hikes

In addition, If the index your card is tied to goes up, your issuer can apply that to your pre-existing balance. So, even if the index increased only at the end of the period, the credit card company can charge increased interest for the entire billing period.

For loans, the rates on variable-rate agreements can decline as indexes go down, but adjustable-rate mortgages don’t necessarily move down with the index. Therefore, there are limits to how much they can decrease.

When variable rates can be cheaper

However, variable-rate loans can be cheaper than fixed-rate loans under specific circumstances. Selecting a variable rate contract can save you a fair chunk if you have an adjustable-rate mortgage with an initial fixed rate, and you decide to flip the home or sell before the rate increases. However, if you stay in the home past the fixed period, your payments can increase significantly, causing difficulty in making mortgage payments.

The bottom line

The best interest rate for you depends on your circumstances and the specifics of the loan. For example, you might prefer a variable rate with a possibility of future decreases, whereas someone else likes the certainty of a fixed rate. Ensure that you understand the pros and cons of both interest rate options before deciding the rate on your next credit card or loan agreement.

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