Variable Rate

Variable Rate
Variable rates are interest rates that change periodically over the life of a loan. The rate can go up or down based on market conditions.

What is a Variable Interest Rate?

Variable rates are interest rates that can rise or fall periodically over the life of a loan. The rate will change based on market conditions.[1] Variable rates are based on a benchmark interest rate, also known as an “interest rate index”, plus an additional margin that is selected by the lender.

What is an interest rate index?

An interest rate index, or “benchmark interest rate”, is a standardized rate that follows the general state of the larger economy.[2] In order to gauge the state of the economy, these indexes often focus on a specific set of economic factors, like, for instance, the performance of US Treasury bonds.[3]

As these economic factors signal strength or weakness in the overall economy, the index rates move up and down accordingly. Interest rates generally go up when the economy is strong and go down when the economy is weak. There are many different index rates out there that are based on different criteria, and individual lenders each decide which rate they want to use for lending.

How do Variable Interest Rates work?

Every variable interest rate has two parts: the index rate and the additional margin. In order to create a variable interest rate, the lender checks whichever index rate they like to use and then adds the additional margin on top of it. The additional margin, beyond the benchmark rate, is always quoted as a percentage of the principal loan amount. It acts as compensation for the lender for any additional risk associated with the specific loan.

Here’s an example: let’s say that a lender offers you a home mortgage variable interest rate that is determined using the LIBOR index plus three percent. (LIBOR stands for London Interbank Offered Rate. This is the rate that banks charge each other for short-term loans.) If the current LIBOR index is one percent, then the variable rate offered by the lender would be four percent (one plus four). If the LIBOR index rises to 1.5 percent, the variable rate would rise as well; it would rise to 4.5 percent.

A variable rate loan calculation usually follows this formula:

  • LIBOR + 3%
  • Prime + 6%
  • 10-year Treasury + 6%

In these examples, the index is given first and the margin percentage follows. In addition to the LIBOR Index, there is also the Prime Rate, which is what US  banks charge their best corporate customers, and the 10-year Treasury, which is an underlying index rate applied to a loan carrying very low or zero risk.[4]

What kinds of loans have Variable Interest Rates?

Credit cards, student loans, mortgages, and auto loans may all have variable interest rate options.

How is a Variable Rate different than a fixed rate?

Whereas variable rates change over time, fixed interest rates do not change at all. A loan with a fixed interest rate of five percent will always have an interest rate of five percent. If the loan is an amortizing installment loan, this means that the loan’s monthly payments would never change. The monthly payments for a loan with a variable rate, on the other hand, can and do change. As the rate moves up and down, the portion of the monthly payment that goes towards the interest moves up and down with it.

The main difference between a variable rate and a fixed rate really comes down to risk versus reward. A fixed rate carries less risk because the rate will never go up, but it carries less reward because the rate will never go down. On the other hand, a variable rate could end up rewarding the borrower with a much lower rate, but it runs the risk of netting them a much a higher rate. The variable rate carries a higher risk, but also offers a higher reward.

References

  1. “Variable Rate”. Dictionary.com. Accessed August 9, 2016 from http://www.dictionary.com/browse/variable-rate
  2. “Floating Interest Rate”. Investopedia. Accessed September 2, 2016 from http://www.investopedia.com/terms/f/floatinginterestrate.asp
  3. “Interest Rate Index.”. Investopedia. Accessed September 2, 2016 from http://www.investopedia.com/terms/i/interest-rate-index.asp
  4. Logue, A. (2016, August 9). Variable Rate Interview [E-mail interview].