What is a variable interest rate?
A variable interest rate (sometimes called an “adjustable” or “variable rate”) is an interest rate on a loan or security that fluctuates over time because it is based on an interest rate or an index of. underlying benchmark that changes periodically.
The obvious advantage of a variable interest rate is that if the underlying interest rate or index goes down, the borrower’s interest payments also go down. Conversely, if the underlying index increases, interest payments increase. Unlike variable interest rates, fixed interest rates do not fluctuate.sese
Key points to remember
- A variable interest rate fluctuates over time because it is based on an underlying interest rate or benchmark that changes periodically with the market.
- The underlying benchmark interest rate or index of a variable interest rate depends on the type of loan or security, but is often linked to 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 is a rate that goes up and down with the rest of the market or with an index. The underlying interest rate or benchmark for a variable interest rate depends on the type of loan or security, but it is often associated with either London Interbank Offered Rate (LIBOR) or the federal funds rate.
Variable interest rates for mortgages, automobiles and credit card can be based on a benchmark rate, such as preferential rate in a country. Banks and financial institutions charge consumers a broadcast compared to this benchmark rate, the deviation depending on several factors, such as the type of asset and the consumer credit rating. Thus, a variable rate can be displayed as “LIBOR plus 200 basis points” (plus 2%).sese
Residential mortgages, for example, can be obtained with fixed interest rates, which are static and cannot change during the term of the mortgage contract, or with a variable or revisable interest rate, which is variable and changes periodically with the market. Variable interest rates can also be found in credit cards, corporate bond issues, swap contracts, and other securities.sese
Due to recent scandals and questions regarding its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and UK regulators, LIBOR will be phased out by June 30, 2023 and will be replaced by the Guaranteed overnight financing rate (SOFR). As part of this phase-out, the one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021.sese
Variable Interest Rate Credit Cards
Variable rate credit cards have a annual percentage rate (APR) linked to a particular index, such as the prime rate. The prime rate changes most often when the Federal Reserve adjusts the federal funds rate, resulting in a change in the rate of the associated credit card. The rates for variable interest credit cards are subject to change without notice to the cardholder.sese
Variable interest rate credit cards can change rates without notifying their customers.
In the “terms and conditions” document associated with the credit card, the interest rate is most often expressed as the prime rate plus a particular percentage, the percentage shown being related to the creditworthiness of the cardholder.seAn example format is prime plus 11.9%.
Variable rate loans and mortgages
Variable rate loans work the same way as 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 repaid on a certain date. As interest rates vary, the required payment will increase or decrease depending on the rate change and the number of payments remaining before completion.
When a mortgage has a variable interest rate, it is more commonly referred to as a adjustable rate mortgage (ARMS). Many ARMs start with a low fixed interest rate during the first few years of the loan, adjusting only after that period expires. 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 limit the rise or fall of the interest rate as it adjusts.seYou can use a online calculator for an estimate of current interest rates on variable rate mortgages.
In most cases, ARMs have rates that adjust based on a predefined margin and a major mortgage index, such as LIBOR, District 11 Cost of Funds Index (COFI), or the Average monthly Treasury index (MTA index). If, for example, someone takes out an ARM with a 2% LIBOR-based margin and the LIBOR is at 3% when the mortgage rate adjusts, the rate resets to 5% (the LIBOR margin plus the index).
Bonds and variable rate securities
For floating rate bonds, the reference rate may be LIBOR.seSome floating rate bonds also use the five, 10, or 30-year US Treasury bond yield as the benchmark interest rate, offering a coupon rate set at a certain spread above the yield on US Treasuries.
Fixed income derivatives may also have variable rates. A interest rate swap, for example, is a futures contract in which a stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps generally involve the exchange of a fixed interest rate for a variable rate, or vice versa, to reduce or increase exposure to interest rate fluctuations or to obtain a rate of interest. slightly lower interest than would have been possible without the swap.seA swap can also involve the exchange of one type of variable rate for another, which is called a base exchange.
Advantages and disadvantages of variable interest rates
Variable interest rates are generally lower than fixed interest rates.
If interest rates fall, the borrower will benefit.
If interest rates rise, the lender will benefit.
Variable interest rates can go to the point where the borrower may have difficulty repaying the loan.
The unpredictability of variable interest rates makes it more difficult for a borrower to budget.
It also makes it more difficult for a lender to predict future cash flows.