Variable Interest Rate: Definition, Benefits, Drawbacks, and Comparison to Fixed

What Is a Variable Interest Rate?

A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.

The obvious advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. Unlike variable interest rates, fixed interest rates do not fluctuate.

How Variable Interest Rates Work

A variable interest rate is a rate that moves up and down with the rest of the market or along with an index. The benchmark for a variable interest rate depends on the loan or security type, commonly tied to SOFR or the federal funds rate.

Variable interest rates for mortgages, automobiles, and credit cards may be based on a benchmark rate, such as the prime rate in a country. Banks charge a spread over the benchmark rate, which depends on the asset type and the consumer’s credit rating. Thus, a variable rate may bill itself as “the LIBOR plus 200 basis points” (plus 2%).

Residential mortgages, for instance, can be obtained with fixed interest rates, which are static and cannot change for the duration of the mortgage agreement, or with a floating or adjustable 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.

Primarily available in the United Kingdom and some European countries, tracker mortgages are variable-rate loans that use a base rate from the Bank of England or the European Central Bank.

Navigating Variable Rates in Credit Cards

Variable-rate credit cards have an annual percentage rate (APR) linked to a specific index, like the prime rate. The prime rate most commonly changes when the Federal Reserve adjusts the federal funds rate, resulting in a change in the rate of the associated credit card. Variable-rate credit cards can change rates without notifying the cardholder in advancewh.

Within the “terms and conditions” document associated with the credit card, the interest rate is most commonly expressed as the prime rate plus a particular percentage, with the listed percentage being tied to the creditworthiness of the cardholder. An example of the format is the prime rate plus 11.9%.

Exploring Variable Rate Loans and Mortgages

Variable-interest-rate loans function similarly to credit cards except for the payment schedule. Credit cards are revolving credit, but most loans are installment plans with set payments until paid off. As interest rates vary, the required payment will go up or down according to the change in rate and the number of payments remaining before completion.

When a mortgage has a variable interest rate, it is more commonly referred to as an adjustable-rate mortgage (ARM). Many ARMs start with a low fixed rate for the initial years, adjusting after that period. 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 put a limit on how much the interest rate can go up or down when it adjusts. You can use an online calculator to get an estimate of current interest rates on adjustable-rate mortgages.

In most cases, ARMs have rates that adjust based on a preset margin and a major mortgage index, such as the LIBOR, the 11th District Cost of Funds Index (COFI), or the Monthly Treasury Average Index (MTA Index). If, for example, someone takes out an ARM with a 2% margin based on the LIBOR, and the LIBOR is at 3% when the mortgage’s rate adjusts, the rate resets at 5% (the margin plus the index).

Delving into Variable Rate Bonds and Securities

Variable-rate bonds may use SOFR as the benchmark. Some variable-rate bonds also use the five-year, 10-year, or 30-year U.S. Treasury bond yield as the benchmark interest rate, offering a coupon rate that is set at a certain spread above the yield on U.S. Treasuries.

Fixed-income derivatives may have variable rates. For example, an interest rate swap exchanges one set of interest payments for another based on a specified principal. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates—or to obtain a marginally lower interest rate than would have been possible without the swap. A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

Weighing the Pros and Cons of Variable Interest Rates