Variable-Rate Loan – What Is It and How Does the Interest Work?
When you borrow money, you typically need to repay the amount you borrowed plus some interest. The amount of interest that accrues is based on how much you borrow and the interest rate of the loan.
That interest rate can either be fixed or variable. When the interest rate is variable, it can change over time. That means both your monthly payment and the overall amount of interest you’re set to pay over the life of the loan are subject to change.
Think a variable-rate loan makes sense for you? Read on to learn more about this particular type of credit product and the upsides and downsides of getting one.
What Is a Variable-Rate Loan?
A variable-rate loan isn’t really a type of loan or line of credit in the same way that a mortgage, student loan, credit card, or auto loan is. Those are specific types of loans designed for specific purposes. “Variable-rate” simply describes how interest accrues on the loan balance.
If a loan like a mortgage, auto loan, or personal loan has a variable rate, that means that the loan’s interest rate can change over time. It isn’t fixed at the same amount for the life of the loan.
When you apply for a loan or line of credit, you can often choose whether to accept a fixed interest rate or a variable interest rate. If you choose a variable rate, the loan disclosures should clearly spell out how and when the interest rate changes.
How Variable-Rate Loans Work
Variable-rate loans work much like other loans. You receive a sum of cash and pay it back over time. Each month, you make your monthly payment which includes all accrued interest and a portion of the principal.
With a variable-rate loan, there are three things to pay attention to.
When you apply for a variable-rate loan, the lender is required by law to provide a loan offer that describes the terms of the loan. This offer spells out how much you can borrow, any fees you have to pay, the loan term, and the initial interest rate of the loan.
The lower the initial rate, the less expensive the loan will be at first. People are often drawn to variable-rate loans because they can have lower interest rates than fixed-rate loans.
Rate Lock and Adjustment Periods
Many variable-rate loans come with initial interest rate lock periods, also known as fixed-rate periods. During this period, the interest rate of the loan doesn’t change. Once the initial period ends, your interest rate can change after each adjustment period — often each year.
A popular type of variable-rate loan is an adjustable-rate mortgage (ARM). You’ll often see these quoted using terms like “5/1,” “7/1,” or similar. The first number represents the rate lock period. The second represents the adjustment period.
To use a 5/1 loan as an example, the interest rate on the loan is fixed for the first five years — the “5.” After five years pass, the interest rate can change once per year — the “1.”
Interest Benchmark, Caps, and Minimums
Your loan documents should also include information about what benchmark serves as the basis for your loan’s interest rate. There are many popular interest rate benchmarks such as the London Interbank Offered Rate (LIBOR), the prime rate, the federal funds rate, or various government bond rates.
If the benchmark rate increases, the interest rate of your loan will likely increase. If it falls, your rate might fall. Your loan documents should note whether your loan has a maximum or minimum interest rate it can’t move past.
Variable Interest Rate Example
Let’s say you get a home loan for $250,000. You apply for a variable-rate loan to lock in a low interest rate and keep your early loan payments in check. Your loan offer includes a 30-year repayment period, a five-year interest rate lock, and an initial interest rate of 4%.
You make your monthly payment of $1,193.54 each month. After five years your loan balance is $226,118.78. You’ve paid a total of $71,612.40, of which $47,731.18 covered interest and $23,881.22 went toward principal.
After five years, your lender lets you know that the interest rate on your loan will change due to increases in market rates. For the next year, the interest rate of the loan will be 6% — an overnight increase of 2%.
Because each mortgage payment needs to cover accrued interest plus a portion of interest, your monthly payment will increase to $1,456.89, an increase of $263.35 over your previous monthly payment. At the end of the year, your loan’s rate may adjust again based on changes in the rate environment.
If rates hold steady or drop, a variable rate mortgage, or any variable loan, can be cheaper than a fixed rate mortgage. However, you face the risk of rising interest rates causing your monthly payment to rise — and potentially busting your budget.
You can use a loan calculator to find out how much you’ll pay over the life of a loan and adjust the interest rates to see how rate changes could impact you.
Types of Variable Rate Loans
There are many different types of loans that can come with variable interest rates.
Credit cards give borrowers an easy way to borrow money on short notice without having to apply for a brand new loan. However, they’re notorious for their high interest rates.
The vast majority of credit card agreements state that the interest rate on your card balance is variable and can adjust without notice. These
Personal loans can come with fixed rates or variable rates. It’s up to the lender to choose which to offer and you can choose which type of loan to apply for. In general, variable-rate loans will come with lower initial interest rates than fixed-rate loans.
Lines of Credit
If you get a line of credit, such as a personal line of credit or a home equity line of credit, it will typically come with a variable interest rate.
Student loans can have either fixed or variable rates. Government loans generally have fixed interest rates, while private student lenders can choose whether to offer fixed or variable rates for their loans.
When you get a mortgage, you can apply for either a fixed-rate mortgage or a variable-rate mortgage — more commonly known as an adjustable-rate mortgage. Adjustable-rate mortgages typically have fixed rates for five to 10 years, then adjust every year based on the benchmark rate.
Variable-Rate vs. Fixed-Rate Loans — What’s the Difference?
The primary difference between variable-rate and fixed-rate loans is that the interest rate on a variable-rate loan can change. Fixed-rate loans have interest rates that will never change.
However, this one difference has a massive impact on how these loans work.
In general, for people with the same credit score, the initial interest rate on a variable-rate loan is lower than the rate on a fixed-rate loan.
However, the drawback of that lower initial rate is uncertainty. With a variable-rate loan, the interest rate could skyrocket after the rate lock period ends. You could find yourself face-to-face with monthly interest payments that are hundreds of dollars larger than expected. On the other hand, rates could drop, saving you money.
Fixed-rate loans could be more expensive initially, but they provide certainty. If your monthly payment on a fixed-rate loan is $500, you know that payment won’t change even if market interest rates spike.
Pros & Cons of Variable-Rate Loans
Variable-rate loans can be appealing for their lower upfront interest rates, but they could hide higher long-term costs. It’s therefore important to weigh their pros and cons.
Pros of Variable-Rate Loans
Variable-rate loans typically come with lower interest rates and payments to start with, which helps them draw borrowers looking for cheap loans.
- Low Initial Rate. All else being equal, borrowers typically pay a lower initial interest rate if they opt for a variable-rate loan over a fixed-rate loan.
- Rates May Fall Over Time. If you have a variable-rate loan, the interest rate could decrease if market rates drop over the life of the loan.
- Lower Monthly Payment. Because of the lower initial rate, the monthly payment for the loan is lower, at least to start.
- Easier Qualification. In some cases, buyers have an easier time qualifying for variable-rate loans more easily because of their lower monthly payments.
Cons of Variable-Rate Loans
Variable-rate loans expose borrowers to risk. The primary risk is that rising rates could make the payment unaffordable.
- Rates Can Rise Over Time. If market rates increase, the interest rate on your loan could rise to more than double or triple the original rate. This could significantly increase the total cost of the loan.
- Payment Changes Over Time. As interest rates change, the monthly payment required alsos change. This makes it more difficult to budget, even if the changes aren’t drastic.
- Complexity. Variable-rate loans can be difficult to understand when compared to other loans. You have to account for changing rates, rate-lock periods, adjustment periods, and interest rate caps when trying to decide if a loan is a good idea.
Should You Get a Variable Rate Loan?
Variable-rate loans can be powerful tools in the right situations. You just need to make sure you understand how they work and are prepared to use one properly.
Some situations where a variable-rate loan can be a good idea include:
- You Plan to Pay the Loan Off During the Rate-Lock Period. If you plan to pay the loan off early and never let the interest rate adjust, you won’t face any of the risks of rising rates. This is a common strategy for homebuyers who plan to move before the first adjustment period.
- You Can Afford Higher Payments. If you have space in your budget for higher monthly payments — up to the payments required under the maximum possible interest rate — you might consider taking a chance on a variable-rate loan.
- Market Rates Are High. If market interest rates are already high, you might bet that they’re unlikely to increase further. In that case, your risk of significantly higher future payments is lower, and the loan could be a good deal.
Variable-Rate Loan FAQs
Variable-rate loans can be complicated thanks to the many additional terms they have compared to fixed-rate loans. It’s important to understand how they work before you sign on the dotted line.
Do Variable Rates Ever Go Down?
Yes, it is possible for variable rates to go down. If the benchmark interest rate for your loan has decreased since the last time your loan’s rate was set, your lender may adjust the rate downwards so long as it’s not already at the minimum rate outlined in your loan agreement.
Can I Change a Variable-Rate Loan to a Fixed-Rate Loan?
Yes, it is possible to change a variable-rate loan to a fixed-rate loan. You can always refinance the loan. Refinancing allows you to adjust all of the loan’s terms, including the repayment period and whether the rate is fixed or variable.
Some lenders may offer the option to convert from a variable rate to a fixed rate without refinancing. However, you might have to pay a fee to do so.
Is an Adjustable-Rate Mortgage (ARM) the Same as a Variable-Rate Loan?
Yes, an adjustable-rate mortgage (ARM) is a type of variable-rate loan that borrowers can use to purchase a home or refinance an existing home loan.
ARMs are popular because they have lower payments in the short-term. However, like other variable-rate loans, they expose the borrower to the risk that payments could rise over time.
When you take out a variable-rate loan, you secure lower initial interest rates and monthly payments while accepting the risk that interest rates might rise in the future. On the other hand, if rates fall, you could benefit from an even lower monthly payment.
In general, variable-rate loans are good for short-term loans where the interest rate risk is minimal. For example, if you only plan to live in a home for a few years before selling it, an ARM could be a good choice.
However, you might consider a variable-rate loan even for a longer-term loan, such as a 30-year mortgage. You just have to be willing to accept the chance that your monthly payment could increase at some point in the future.