Variable Interest Rate: Definition, Pros & Cons, Vs. Fixed

What Is a Variable Interest Rate?

A variable interest rate is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.

The advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. Unlike fixed interest rates, variable interest rates do not fluctuate.

Key Takeaways

• A variable interest rate fluctuates because it is based on an underlying benchmark interest rate or index that changes periodically with the market.
• The benchmark interest rate or index for a variable interest rate depends on the type of loan or security, but it is frequently linked to the LIBOR or the federal funds rate.
• Variable interest rates can be found in mortgages, credit cards, corporate bonds, derivatives, and other securities or loans.

Understanding Variable Interest Rates

A variable interest rate moves up and down with the market or along with an index. The benchmark interest rate or index for a variable interest rate depends on the type of loan or security, but it is often associated with either the London Inter-Bank Offered Rate (LIBOR) or the federal funds rate.

Variable interest rates for mortgages, automobiles, and credit cards may be based on a benchmark rate, such as the prime rate in a country. Banks and financial institutions charge consumers a spread over this benchmark rate, with the spread depending on factors such as the type of asset and the consumer’s credit rating. Thus, a variable rate may bill itself as “the LIBOR plus 200 basis points” (plus 2%).

Residential mortgages can be obtained with fixed interest rates, which are static and cannot change for the duration of the mortgage agreement, or with a floating or adjustable interest rate, which changes periodically with the market. Variable interest rates can also be found in credit cards, corporate bond issues, swap contracts, and other securities.

Variable-Interest-Rate Credit Cards

Variable-interest-rate credit cards have an annual percentage rate (APR) tied to a particular index, such as the prime rate. The prime rate most commonly changes when the Federal Reserve adjusts the federal funds rate, resulting in a change in the rate of the associated credit card. The rates on variable-interest-rate credit cards can change without advance notice to the cardholder.

Within the “terms and conditions” document associated with the credit card, the interest rate is most commonly expressed as the prime rate plus a particular percentage, with the listed percentage being tied to the creditworthiness of the cardholder. An example of the format is the prime rate plus 11.9%.

Variable-Interest-Rate Loans and Mortgages

Variable-interest-rate loans function similarly to credit cards except for the payment schedule. While a credit card is considered a revolving line of credit, most loans are installment loans, with a specified number of payments leading to the loan being paid off by a particular date. As interest rates vary, the required payment will go up or down according to the change in rate and the number of payments remaining before completion.

When a mortgage has a variable interest rate, it is more commonly referred to as an adjustable-rate mortgage (ARM). Many ARMs start with a low fixed interest rate for the first few years of the loan, only adjusting after that period has expired. Common fixed-interest-rate periods on an ARM are three, five, or seven years, expressed as a 3/1, 5/1, or 7/1 ARM, respectively. There are also usually adjustment “caps” that put a limit on how much the interest rate can go up or down when it adjusts. You can use an online calculator to get an estimate of current interest rates on adjustable-rate mortgages.

In most cases, ARMs have rates that adjust based on a preset margin and a major mortgage index, such as the LIBOR, the 11th District Cost of Funds Index (COFI), or the Monthly Treasury Average Index (MTA Index). If someone takes out an ARM with a 2% margin based on the LIBOR, and the LIBOR is at 3% when the mortgage’s rate adjusts, the rate resets at 5% (the margin plus the index).

Variable-Interest-Rate Bonds and Securities

For variable-interest-rate bonds, the benchmark rate may be the LIBOR. Some variable-rate bonds also use the five-year, 10-year, or 30-year U.S. Treasury bond yield as the benchmark interest rate, offering a coupon rate that is set at a certain spread above the yield on U.S. Treasuries.

Fixed-income derivatives also can carry variable rates. An interest rate swap, for example, is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates—or to obtain a marginally lower interest rate than would have been possible without the swap. A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

Pros and Cons of Variable Interest Rates

• Variable interest rates are generally lower than fixed interest rates.
• If interest rates go down, the borrower will benefit.
• If interest rates go up, the lender will benefit.
• Variable interest rates can go up to the point where the borrower may have difficulty paying the loan.
• The unpredictability of variable interest rates makes it harder for a borrower to budget.
• It also makes it harder for a lender to predict future cash flows.