Variable Rate Loans

What Is a Variable Rate Loan?

A variable rate loan has a changing interest rate based on the current financial markets.This can allow borrowers to potentially benefit from lower rates and a reduced monthly payment. However, it’s important to consider the risks involved, as variable rate loans come with the possibility of interest rate increases and higher payments as well. 

Many Americans opt for a variable loan interest rate when given the opportunity. In fact, 40% of Americans say they would consider a variable rate mortgage.¹ Here, we will explore how they work, how they compare to fixed rate loans, and what your other financial alternatives are. 

While a fixed interest rate loan has the same rate throughout the repayment process, the rate for a variable rate loan changes, hence the name. This type of funding may provide potential savings on interest payments. However, it’s also important to note that loan interest rates may also increase some months, depending on market conditions. 

When it comes to repayment, borrowers repay their balance in monthly installments over a predetermined period of time, which may vary depending on which lender you go with. 

Advantages 

The primary advantage of variable interest rate loans is their potential to save money while paying back a loan. This flexibility and potential for cost savings are what make variable or adjustable interest rate loans so attractive to many borrowers. 

When financial markets are doing well, those with a variable interest rate will often enjoy a lower monthly payment, thereby enhancing their financial flexibility and freeing up funds for other uses, allowing borrowers to pay off debt and still save money. 

Disadvantages

While variable interest rate loans offer potential savings, they come with the risk of rising interest rates resulting in increased monthly payments. The fluctuating nature of these variable loans can make budgeting a challenge, as payment amounts could vary from month to month. 

Finally, in the event of an upward trend in the economy, it is possible that you will end up paying a higher amount of interest over the duration of the loan as compared to a loan with fixed interest rates.

How Do Variable Interest Rate Loans Work?

Before applying for a variable or adjustable interest rate loan, start by researching lenders and comparing their rates and terms. After you have found a lender you think will be a good fit, go ahead and submit an application. The application will typically ask for basic information like your name, address, income, and desired loan amount. 

You can usually expect a credit check to take place during the application process so lenders can get more insight into your financial history and confirm you are not currently going through the bankruptcy process. If approved, review the loan offer, sign the agreement, and receive the loan funds. 

A variable rate will change periodically throughout the repayment process due  an index that changes periodically with the market. 

These are some of the most common indexes that lenders use:

• LIBOR Index: The London Interbank Offered Rate (LIBOR) is the average interest rate that big banks charge each other for short-term lending. It’s often used as a base rate.
• Prime Rate: This is typically the interest rate that banks offer to customers with great credit scores. Many lenders use the Prime Rate as a reference to set interest rates.
• Federal Cost of Funds Index (COFI): COFI is the average interest rate for some types of mortgages and securities. It reflects the monthly interest expenses reported by the COFI Reporting Members.

What is a Variable Rate Mortgage?

A variable rate mortgage is a home loan with variable rates. The rate you get on a mortgage depends on your credit score, debt-to-income (DTI) ratio, and the benchmark index rate used by the lender. Comparing lenders will help you find the best variable interest rate on a mortgage. 

The structure of a variable rate mortgage consists of these two rates:

• Indexed Rate: This is the baseline rate of your mortgage. 
• Variable Rate Margin: The margin is a fixed percentage added on top of the indexed rate to maximize the lender’s profit. 

When the index goes up or down, your mortgage rate adjusts based on the new indexed rate plus your fixed margin. For example, if the indexed rate is 3% and your margin is 2%, your total interest rate would be 5%. This means your monthly payments can change over time—sometimes in your favor. For this reason, many people prefer a variable rate mortgage. 

If the variable interest rate decreases, you can end up paying fewer interest fees on the home loan compared to someone that has a fixed rate. But keep in mind that your rate can also increase unexpectedly, raising your monthly payment by a little or a lot.

Variable Rate Loan vs. Fixed Interest Rate Loan

Which Rate is Better?

The best type of rate for a loan depends on the borrower’s financial profile and their repayment preferences. Before you decide between a fixed or variable rate, it’s essential to consider a few factors, such as your financial flexibility. Can you afford to pay a higher monthly payment if the rate unexpectedly goes up? If your cash flow is not high enough to cover a higher than expected mortgage payment, then a fixed rate may be better for you. 

These additional factors should also be considered when choosing between a fixed or variable rate:

• Interest Rate Environment: Consider the current market and the volatility of variable rates. Choose fixed if rates are low and expected to rise, and variable if rates are high or expected to fall.
• Interest Rate Spread: Consider the rate differences. If the spread is wide and the variable rate is much lower, a variable rate might offer initial savings.
• Risk Tolerance: Fixed rates offer financial stability and peace of mind. But variable rates can fluctuate, so they’re best if you’re comfortable with potential changes in monthly payments.
• Loan Term: Variable rates may be better for shorter term lending since there’s less time for rates to increase. In contrast, longer terms might benefit from predictable fixed rates.
• Loan Flexibility: If you anticipate refinancing or paying off the loan early, variable rates may offer more flexibility with lower penalties.
• Current Financial Situation: If you are expecting your income to increase, a variable rate might work as you can handle potential rate hikes. But if you have stable income and high debt, then fixed rates can provide financial certainty.
• Economic Outlook: If the economy is expected to strengthen, rates could increase, making fixed rates more attractive. But if an economic slowdown is expected, variable rates might be a better bet due to potential rate cuts.

Types of Variable Rate Loans

Variable interest rates are not unique to a specific kind of loan. They can be associated with:

• Mortgage Loans: Funding used to purchase real estate, typically a home for the borrower. Mortgage rates usually vary, depending on the borrower’s credit score, income, property value, etc. 
• Home Equity Lines of Credit: A credit line where the limit is calculated based on the equity in the borrower’s collateral. 
• Auto Loans: Funding used to purchase a vehicle. 
• Credit Cards: Revolving lines of credit that typically do not require collateral. 
• Personal Loans: A versatile form of funding best suited for financial emergencies. 
• Student Loans: Funding used to pay for higher education, usually at a college or university. 

What Impacts Variable Rate Loans?

Key factors influencing your interest rate include inflation rates, economic growth indicators, changes in economic activity and monetary policies set by central banks. 

For example, during the Covid-19 pandemic, the Federal Reserve assisted in pushing interest rates for mortgages below 3%. The purpose of this drop was to stimulate the market and encourage borrowers to purchase real estate and take out mortgages.

Also, the borrower’s creditworthiness and the lender’s specific terms and conditions can also affect the interest rate on variable rate loans. Other factors that can go into the decision making process for loan rates are federal regulations and state-specific laws. 

Variable Rate Loan Calculations

Interest rates for variable rate loans are calculated using several factors, including: 

• Annual percentage rate (APR). 
• Loan term. 
• Current market conditions. 

Understanding the factors that go into determining your interest rates can help you decide whether a specific loan type may be right for you or not.

Should You Get a Variable Rate Loan?

Whether you should get a loan with a variable rate depends on your financial situation and other factors. Before applying for any type of loan, consider what you can afford to pay monthly, how rate increases may affect you, and your future plans. 

If you can only afford to pay a certain amount every month, or intend to get a long repayment plan, then fixed rates may be more ideal since they offer stability. But if you have financial flexibility and only need funding for a short period of time, then perhaps you should consider getting a variable rate on a loan. 

Variable Rate Loan FAQs