What Is a Variable Interest Rate?

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A variable interest rate is an alternative to a fixed interest rate. Variable rates move up and down over time, while fixed rates stay the same. As the interest rate changes, your monthly debt payment could change due to an increase or decrease in accrued interest.

Read on to learn more about how variable interest rates work, types of variable interest rates, and alternatives to loans with variable rates.

What Is a Variable Interest Rate?

A variable interest rate is one that can fluctuate over time, causing your loan payments to change. Variable rates are common on credit cards and home equity lines of credit (HELOCs). You may also find variable-rate private student loans. Mortgage loans can offer a variable rate as well, but these are special home loans called adjustable-rate mortgages.

How Does a Variable Interest Rate Work?

Variable rates are tied to a specific financial index, which often features a base interest rate used by lenders. You’ll find the index listed in your loan documents or a credit-card cardmember agreement. Existing loans may use the LIBOR index, which has been discontinued for new loans and will be phased out by mid-2023. Common indexes currently in use include:

• The one-year constant-maturity treasury securities (CMT)
• The Cost of Funds Index (COFI)
• The Wall St. Journal Prime Rate
• Secured Overnight Financing Rate (SOFR)
  

Note

Your lender or credit card issuer usually adds a “margin” to your variable interest rate, which is a fixed percentage rate tied to the index. So if your margin is 5% and the lender uses SOFR, then your variable rate will always be SOFR plus 5%.

As the index moves up and down, your monthly payment and total repayment costs change as well. For example, if you take out a 30-year fixed-rate $200,000 loan with an interest rate of 3.5%, your monthly payment would be $898.09. Your total interest costs would be $123,311.97.

However, if you took out a 30-year, 5/1 adjustable rate mortgage (ARM), it would be different. A 5/1 ARM is a mortgage with a fixed interest rate for five years. After that, the lender updates the interest rate based on the index the rate follows. It's common for variable-rate loans to have a lower starting interest rate than fixed-rate alternatives. Variable rates present less risk to lenders, as the rate changes with market conditions.

So if you had a 30-year, 5/1 ARM with a starting rate of 3.25%, fixed for five years, adjusted by 1 percentage point after that five-year period, and subsequently adjusted by 0.5 percentage points five times over the life of the loan, your starting monthly payment would be $870.41. However, your payment would eventually rise to $1,342.32. You'd also pay a total of $235,061.37 in interest over the life of the loan. This kind of variable-rate loan would cost more than a fixed-rate loan.

Note

There are different kinds of adjustable-rate mortgages, including 3/1 ARMs with fixed rates the first three years; 5/1 ARMs with fixed rates for the first five years; 7/1 ARMs with fixed rates for the first seven years; and 10/1 ARMs with fixed rates for the first decade.

Types of Variable Interest Rates

You could get a variable interest rate on a mortgage, home equity line of credit, credit card, and even a student loan.

Adjustable-rate mortgages lock in your initial starting rate for a period of time, then implement a variable rate. Variable rates on most other kinds of loans don't work this way, though.

With variable-rate credit cards and private student loans, for example, the interest rate and monthly payment could change right away and adjust as often as monthly.

Pros and Cons of Variable Interest Rates

• Lower starting rates
• The possibility that your rate could decline

• A lack of certainty about repayment costs
• The possibility that your rate could rise

Pros Explained

• Lower starting rates: Lower interest rates make your loan more affordable at the beginning, which may make a difference in loan approval if you don't have much income.
• The possibility that your rate could decline: Because the rate varies, there’s always the chance that your rate goes down. This could lower your monthly payment and make total repayment costs cheaper, however, just because interest rates drop doesn't always mean that your monthly payments will.

Cons Explained

• A lack of certainty about repayment costs: Your monthly payment could change drastically and you can’t predict how much you’ll pay in interest over time since the rate can change.
• The possibility that your rate could rise: Just as your rate could decline and help you save money, a variable interest rate could rise and increase your monthly payment, making total repayment costs higher.

Limitations of Variable Interest Rates

Variable interest rates could affect your ability to repay your loans in full if rates rise and payments become unaffordable. Anyone considering a loan with a variable rate should review the loan documents carefully to find out how much, and how often, rates can adjust. You should make sure you can afford the highest possible payment under your loan terms.

Alternatives to Variable Interest Rates

Fixed interest rates may be the easiest and most sensible alternative to a variable-rate loan. A fixed rate is not tied to a financial index and your lender provides a rate upfront based on current economic conditions, your credit score, and other qualifying factors. Your rate remains the same for the entirety of your repayment term with a fixed-rate loan.

Depending on the loan or line of credit you’re trying to get, you might have the option to choose either a fixed or variable rate. This option is often available to you with private student loans, and mortgages, for example. However, home equity lines of credit (HELOCs) and credit cards most often have variable rates, so you will have fewer options if a fixed rate is important to you.

Variable vs. Fixed Interest Rates

Key Takeaways

• Variable interest rates can fluctuate over time because they are tied to a specific financial index.
• Variable rates can move up or down, which means what you pay in interest could increase or decrease over time.
• Total loan repayment costs and monthly payments can change along with your interest rate.
• Mortgages, home equity lines of credits, credit cards, and student loans often offer variable interest rate options.