How Do Variable Interest Rates Work?
Taking out a personal loan can often mean getting bombarded by financial jargon. Our goal is to demystify these terms by breaking them down into language that anyone can understand. So if you’ve ever wondered what a “variable interest rate” is, you’ve come to the right place!
What is a variable interest rate?
There are two kinds of interest rates associated with borrowing money with a personal loan or a credit card: fixed and variable.
“A variable interest rate is an interest rate on a loan or security that moves up and down over time,” explained Joe Bailey, Business Development Consultant at My Trading Skills. “It owes its fluctuation to being based on an underlying benchmark rate/index that changes from time to time.
“In contrast,” he continued, “a fixed interest rate does not fluctuate but remains steady throughout the life of the product.”
When you’re borrowing, lending, or investing money, it’s all about managing your risk. Do you want smaller rewards that are much safer to achieve, or do you want greater rewards that come with a higher likelihood of the whole thing going south?
So it is with variable interest rates: you may realize lower rates, but you risk getting stuck with higher ones.
“The advantage here is if the underlying interest rate/index declines, so will the interest you will pay on your loan or security,” said Bailey. “Conversely, if this underlying interest rate/index goes up, you'll end up paying higher interest on your loan facility. This means you will have to pay more money back to your lender.”
Here’s an example.
How do variable rates determine whether they should move up or down? By tying themselves to another interest rate and following its movements.
“In layman's terms, variable interest rate means an interest rate which is based on a benchmark interest rate or an index or simply market rates,” said Rishit Shah of TallySchool.
Shah offered the following example to illustrate how this relationship works.
“You take a loan at 8 percent variable interest rate based on LIBOR (London Interbank Offered Rate). Now, if the LIBOR goes down, your interest rate also goes down. Similarly, if the LIBOR goes up, your interest rate also goes up.
"Therefore, it is called a variable interest rate because it varies or changes on the basis of some other benchmark rate, which in our example is LIBOR.”
Shah also clarified that variable rates are also sometimes referred to as “floating” or “adjustable” interest rates.
Benchmark rates: The prime rate and LIBOR.
In Shah’s example, he used a loan that was tied to the London Interbank Offered Rate or LIBOR rate. This is the rate that banks use to lend money to each other, and it is often used as a benchmark rate in foreign transactions.
For U.S. borrowers, on the other hand, a different rate is often used. If you live in the U.S. and are applying for a loan, that loan will likely be tied to the “prime rate” which is the rate that banks use when lending to their very best, most reliable customers.
“Variable interest rates are tied to the prime rate which is controlled by the Federal Reserve,” said Levi Sanchez of Millennial Wealth, LLC.
“The Federal Reserve controls monetary supply and therefore can influence interest rates. In a rising interest rate environment, variable interest rates used by consumers are also increasing. In a lower interest rate environment, the interest rates for consumers would, in turn, be lower.”
If you have a variable interest rate tied to the prime rate, it is likely set at a certain percentage above that benchmark. For instance: If your variable rate is five percentage points higher than the prime rate, a change in the prime rate from six percent to seven percent would cause your variable rate to change from 11 to 12%.
The pros and cons of variable interest rates.
Like most other things in life, both variable and fixed interest rates come with their respective pros and cons. The difference is that those pros and cons will vary depending on larger economic forces, as variable rates are better in some market conditions than in others.
“If the benchmark interest rate goes down, your interest payments also go down and you have to pay less money in interest,” said Shah. But the reverse is also true. “You may have to pay significantly higher interest payments if the benchmark rate goes up. In other words, you won't get peace of mind since the rates are always fluctuating,” he added.
And for longer-term loans, Shah advised that the odds of your rate going up are much higher: “If you expect to keep a loan for a long time, the chances are greater that the interest rate might go up as, gradually, the economy grows and prices go up in the long run.”
Shah laid out two additional benefits beyond the prospect of lower interest rates: Better access to credit and fewer penalties for early repayment.
“If your credit is not good enough, you can get a loan on a variable interest rate since it is based on a benchmark,” he said, adding that “in a variable interest rate mortgage, you don't need to worry about penalties if you want to complete your mortgage payments early or switch the lender.”
However, access to credit always comes with a flipside: Just because you can take out a loan doesn’t mean you should.
Watch out for low introductory rates.
Senior financial analyst Trish Tetreault of FitSmallBusiness.com explained the dangers of low “introductory offer” rates that come with many variable rate loans, especially for borrowers who have poor credit:
“In general, a variable interest rate will begin with a lower introductory rate and will rise and fall based on a price indicator. Often the low introductory rate seems manageable, but the gradual increase in rate over the course of your loan can result in an interest rate and payments that quickly become unaffordable.
“Borrowers with less than perfect credit are often offered loans with variable interest rates and later find the rate increases to be unmanageable. As such, it's crucial to understand when your rate may increase, and whether or not there are caps on the amount the rate can increase."
If you have recently taken out a bad credit loan with an introductory rate, here is Tetreault's advice:
“If your introductory rate is fixed for a certain period of time, use this time to improve your credit score. As your credit score improves you'll be able to qualify for loans that offer better rates and terms, and you may be able to refinance your way out of your variable rate loan.”
Know before you borrow.
If you want to take advantage of a variable interest rate on a personal installment loan, an auto loan, or a mortgage, you’re going to need to do some research first. The more knowledge you have, the more confident you can be in your decision.
Levi Sanchez is a Certified Financial Planner™, Certified Private Wealth Advisor®, Certified Exit Planning Advisor®, Behavioral Financial Advisor™ designee and Founder of Millennial Wealth, LLC (@millennialwlth), a fee-only financial planning firm for young professionals and tech industry employees. Levi’s been quoted in the New York Times, Business Insider, Forbes, and is a frequent contributor to Investopedia. He is an avid sports fan, personal finance, and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!