Basics of Variable Rate Loans
When you borrow money, interest can be charged in one of two ways: with a fixed rate, or with a variable rate. Sometimes you get to choose, but sometimes the type of loan (or your lender) dictates what your options are. Fixed rates are often available with larger loans like home loans, while variable rates are common with consumer debt like credit cards and home equity lines of credit (HELOCs). Whether or not you get to choose, it’s essential to know how a variable rate loan works before you use one.
How They Work
A variable rate loan is (from your lender’s perspective) a flexible loan. The interest rate can change (or "vary"), meaning lenders can raise or lower the rate over time. If they want to increase their earnings, they can raise the rate; if they want or need to keep the loan competitive, they can let the rate fall.
For each time period that you borrow (every year or every month, for example), you’ll pay interest on your outstanding loan balance according to whatever your rate happens to be. With fixed rate loans, you know what that rate will be – it will stay the same throughout the life of your loan. But variable rates make predictions difficult.
Why it Matters
Your interest rate is important. In particular, it influences:
- How much you’ll pay in interest charges (the higher the rate, the more it costs to borrow)
- What your monthly payments will be
If your rate increases, you may find that a loan (or anything you purchase on credit) is substantially more expensive than you expected – and possibly more than you can afford. There’s also the opportunity that your rate will decrease, making things more affordable, but that’s rarely a cause of concern.
Example: you have a credit card balance of $10,000, and the rate is currently 10%. You make minimum payments of 2% of the loan balance (this is already getting ugly), starting at $200 per month and decreasing. Your interest costs are roughly $83 per month, so you only reduce your loan balance by $117 per month with each payment. Assume your interest rate increases to 19% after two years – 19% is not unheard of. At that point you’d have a balance of $7,545 and your monthly interest costs would jump to $119 per month – each monthly payment of $150 would hardly make a dent in your debt!
To run those numbers yourself, use a calculator for credit card minimum payments.
With large loans like adjustable rate mortgages, a slightly higher rate can cause severe and immediate problems. Your required monthly payment might increase several hundred dollars per month or more. That’s money you’ll need to come up with right away – not just an interest cost that you can ignore until later (which will inevitably come sooner than you’d like).
How Variable Rates Work
Loans with variable interest rates often start with lower rates than fixed rate loans, all other things being equal. You’re sharing some risk with the lender (the risk that interest rates will rise) so they’re willing to give you a break up front.
Rates are typically based on an “index” such as LIBOR or the Prime Rate, plus an additional margin based on your credit, income, and other factors. For example, if the index rate is 4% and your lender chooses a margin of 3%, you will pay interest at a fully indexed rate of 7%.
Rates float up and down when the underlying index moves. For example, LIBOR might move based on changes in the economy, and your loan's interest rate would follow along and adjust.
Variable rates are available (but not always the only option) with credit cards, student loans, auto loans, mortgages, personal loans, and more.
Which is Better: Variable or Fixed?
You might wonder if it makes sense to use a variable rate. If you can predict the future, it’s an easy decision: use a variable rate loan when rates will fall, and use fixed rate loans when rates will rise.
Unfortunately, the future is uncertain, so you’ll have to make some assumptions and take some risk when you decide.
Predicting the direction of interest rate moves is extremely difficult; predicting the timing and direction of those moves is even more maddening – even seasoned experts get it wrong.
Ask yourself some important questions about your loan and your financial situation to get some insight:
- Does this purchase and loan make sense currently – whether or not interest rates move in the future and I miss out?
- Can I afford to pay more if rates go up? How much more, and how likely is it that my loan will get there?
- Will I really earn more money in a few years (most people assume they will, but it doesn’t always work out that way)?
Variable rates are generally riskier than fixed interest rates: there’s always the possibility that your payment (and the cost of the item you purchased) will increase. With fixed rates, you might lose out if interest rates fall, but at least you know the worst-case-scenario. If rates go down, you might even have the opportunity to refinance into a lower cost loan.