Variable Interest Rate

Updated on April 12, 2024
Article byPrakhar Gajendrakar
Edited byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Variable Interest Rate?

Variable interest rate refers to a mortgage or loan interest rate that fluctuates with the market conditions. The interest levied on variable loans depends on the reference or benchmark rate—an index.

The interest rate varies; neither the lender nor the borrower has any control over it. Therefore, it is also called a floating interest rate or an adjustable interest rate. In contrast, fixed interest rates remain constant throughout the period of the debt obligation.

Key Takeaways

  • A variable interest rate is a fluctuating interest levied on various loans and mortgages obligations. It is not fixed and fluctuates according to market conditions and index variations.
  • Variable-rate loans can end up costing more. Borrowers are advised to pay close attention to interest rates and rate comparisons before finalizing.
  • Variable-rate loans are available in the form of credit cards, auto loans, student loans, housing, and mortgage loans. These credit obligations can be obtained with fixed interest rates as well.

Variable Interest Rate Explained

Variable Interest Rate

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A variable interest rate is attached to a benchmark, or reference interest rate called an index. Any variation in the index brings a direct change in the interest rates borrowers pay for their loans. If borrowers apply for variable rate loans without checking the details, they may end up paying more than they expected. Loan details are technical and complex by design. Therefore borrowers must be aware of variable interest loans and credit card policies.

Lenders often like to change their variable rates parallel to changes in important indexes, like the prime rate. When the index changes, so do interest rates—borrowers’ monthly payments go up or down. In contrast, loans based on fixed interest rates have no correlation to index variations and remain constant. In most cases, variable interest loans are considered financial risks, but in a few rare cases, they end up being the better option.

The Truth in Lending Act (TILA) protects borrowers and ensures access to more information pertaining to loan interest rates. The Act is also known as Regulation Z. Lenders are mandated to disclose the APR (Annual Percentage Rate) of loans and mortgages. The APR could be variable interest or fixed interest.

For some loans, borrowers receive a notice before each rate change goes into effect. In loan servicing, for example, the lender must give notice at least seven months before the first increase in mortgage payments. For subsequent changes, lenders must notify two to four months before the monthly payment. Credit card issuers aren’t required to notify changes in variable rates, but some issuers do so voluntarily.

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Examples

Let us look at some examples to understand the practical application of variable interest rates.

Example #1

In Canada, mortgages and mortgage rates have been surging since 2021—every other citizen is burdened with debt. Canada’s National Bank announced most new mortgages would be based on variable rates.

51.3% of new mortgages had variable rates and only 48.7% had fixed rates. In the last five years, this has happened for the first time. This was caused by the huge gap between fixed and variable rates. This also means homebuyers who chose variable rates over fixed rates had 9% more purchasing power.

Example #2

In February 2022, refinanced students loans decreased from 2.96% to 2.78%—five-year loans with variable interests. For variable rate loans, most refinance lenders calculate rates monthly. But they typically restrict it to an upper limit of 18%.

Let us assume that a student refinanced an existing $20,000 loan to a five-year loan— with a variable interest of 2.78%. The student ends up paying around $357 every month. Altogether, the student paid $1,445 in interest. But varying interest rates can fluctuate every month.

Variable vs Fixed Interest Rate

  • Variable interests fluctuate due to market conditions and the underlying index. Fixed-rate interestsFixed-rate InterestsA fixed interest rate is a constant rate of interest levied on debts like loans, mortgages, or bonds.read more remain constant for the whole term.
  • In a declining market, variable rates benefit borrowers—loan payments also drop. Whereas, with fixed-rate loans, even during economic slumps borrowers continue to pay a set amount.
  • Variable-rate borrowers constantly check the rates, so that they can be prepared if the amount rises. Fixed-rate borrowers, on the other hand, know their payment amount and do not worry about any fluctuations.
  • Variable-rate loans can benefit or jeopardize savings—they are risky. Both risks and benefits are lower with fixed-rate loans or fixed rate mortgages.
  • Variable-rate loans are expected to cost more than fixed-rate loans.

Frequently Asked Questions (FAQs)

How often does the variable interest rate change?

It depends on a borrower’s loan terms and the underlying index. Credit cards are commonly referenced against Wall Street Journal’s prime rate (US). Student loans with variable interest may change periodically. At the same time, credit card rates vary based on tandem changes in federal fund rates. Mortgage loans generally stay constant for the first three to five years and then differ periodically.

How do variable interest rates work?

A variable rate loan is tied to an index or recognized benchmark rate and varies periodically. For installments, borrowers pay different amounts every month. The next month’s installment could be an increased or decreased amount.

How is the variable interest rate calculated?

The variable rate includes an indexed rate and a margin. The variable interest formula adds the interest index to the margin. Borrowers with credible credit ratings may qualify for indexed rates pegged on the lender’s prime rate or LIBOR. The interest charged on borrowers fluctuates depending on market changes.

This has been a guide to what is Variable Interest Rate and its definition. We discuss variable interest rate vs fixed-rate mortgage, examples, student loans, and Canada home loans. You may also take a look at the following articles to learn more –

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