Variable Interest Rate

Definition

A variable interest rate is an interest rate on a loan or security that fluctuates over time due to changes in the benchmark interest rate or market index it is tied to. The rate typically adjusts periodically, such as monthly or annually, based on the changes in the underlying benchmark. Borrowers may choose variable interest rates for potential savings and flexibility, but they also take on the risk of potential rate increases.

Phonetic

The phonetic spelling of “Variable Interest Rate” is:ˈveərēəbəl ˈɪntrəst reɪt

Key Takeaways

1. Variable Interest Rate fluctuates over time: Unlike fixed interest rates that remain constant, variable interest rates change based on fluctuations in the market interest rates. This means that the amount of interest you pay may increase or decrease over the life of your loan or investment.
2. Risk and reward balance: A variable interest rate presents a balance between risk and reward. If market interest rates drop, you may benefit from lower interest payments. On the other hand, if market interest rates rise, you may see an increase in your interest payments. This makes it important to carefully consider your financial situation and risk tolerance before choosing a variable interest rate option.
3. Impact on budgeting and planning: Since variable interest rates change over time, it can be challenging to accurately predict your long-term interest payments. This may make it more difficult to budget and plan for future expenses, as you will need to account for the possibility of changes in your interest payments.

Importance

The variable interest rate is essential in business and finance because it directly impacts borrowing costs, loan affordability, and financial decision-making. Unlike fixed interest rates, variable interest rates fluctuate periodically, based on changes in a benchmark or index rate, making them inherently uncertain and potentially more volatile. This feature allows institutions and individuals to benefit from potential decreases in the overall interest rate environment, yet at the same time exposing them to the risk of increasing rates. Understanding and assessing variable interest rates help borrowers, investors, and businesses alike to make informed choices, balance risks and rewards, and ultimately optimize their overall financial management strategy.

Explanation

Variable interest rate, also known as an adjustable or floating rate, serves the purpose of allowing borrowers and lenders to take advantage of fluctuations in market interest rates. By being tied to an underlying benchmark rate, usually the Prime Rate or another financial index, variable interest rates will periodically adjust in response to changes in market conditions. The purpose of a variable interest rate is to provide a dynamic mechanism for borrowers to benefit from lower costs when the market interest rate falls, as well as present an opportunity for lenders to make greater profits when the market interest rate rises. As a financial instrument, variable interest rate loans have gained popularity, particularly in the mortgage industry due to their initial lower interest rates compared to fixed-rate loans. They can be particularly useful for short-term borrowers, as they often come with lower introductory rates that eventually reset according to market conditions. On the other hand, these loans also carry the risk of increasing payments if interest rates rise, which can significantly impact the borrower’s financial stability. Thus, the use of variable interest rate loans is a double-edged sword and requires individuals to carefully assess their risk tolerance, financial capacity, and loan terms before opting for such products.

Examples

1. Credit Cards: Credit cards often use variable interest rates as part of their terms and conditions. The interest rate charged on the outstanding balance depends on a benchmark rate, usually the prime rate. When the prime rate changes, the interest rate charged on the credit card balance also changes, causing the amount of interest paid by the cardholder to vary over time. For instance, if a credit card has an annual percentage rate (APR) of prime rate + 5%, then if the current prime rate is 3%, the total APR on the credit card would be 8%. 2. Adjustable-Rate Mortgages (ARMs): An adjustable-rate mortgage is a type of mortgage loan where the interest rate charged by the lender can change periodically during the life of the loan. The interest rate is tied to a specific financial index, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury’s Constant Maturity rate. When the index changes, the mortgage’s interest rate and monthly payments will also change, depending on the terms of the loan. For example, a 5/1 ARM mortgage might have a fixed interest rate for the first five years, and then switch to a variable interest rate that resets every year based on the chosen index. 3. Home Equity Lines of Credit (HELOC): A home equity line of credit is a revolving line of credit that uses the borrower’s home as collateral. HELOCs typically come with a variable interest rate, which is tied to a benchmark rate such as the prime rate or the U.S. Federal Reserve’s federal funds rate. When the benchmark rate changes, the interest rate on the HELOC also changes, affecting the minimum monthly payments and the total amount of interest paid over time by the borrower. For example, a HELOC with an interest rate of prime + 2% would have a total interest rate of 5% if the current prime rate is 3%.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Prime Rate
• Interest Rate Cap
• Adjustable-Rate Mortgage (ARM)
• Rate Index
• Periodic Adjustment

Sources for More Information

• Investopedia
• AccountingTools
• Credit Karma
• Corporate Finance Institute