What Are Variable Interest Loans?

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Category: Loans
Posted on: 06/29/2021
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Variable interest rate loans are loans or securities with interest rates that can fluctuate over time. These are also often called "adjustable" or "floating rate" loans. Variable interest loans can change their interest rates over time because they are based on what is known as a benchmark interest rate or index. This index can change from time to time, altering the interest rate on variable interest loans. Variable interest loans have several unique qualities, with advantages and disadvantages.

One of the most important potential benefits of a variable interest rate is that the loan's benchmark interest rate can drop over time. This means that your payments can go down, too. However, if that benchmark interest rate rises, borrowers will be paying higher interest rates on their loans. This is the primary characteristic that sets variable-interest loans apart from fixed-interest loans (which do not change over time). Unlike fixed-interest loans, variable-interest loans can experience a rate change at any moment without any warning. That means that lenders do not have to alert their customers before changing their rates.

How Do They Work?

Variable interest loans have rates that can increase or decrease depending on what the wider market is doing or how a certain market index is performing. Benchmark interest rates or indexes for variable interest rates are determined depending on what kind of security or loan you borrow. They are often associated with the federal funds rate and the London Inter-Bank Offered Rate (LIBOR). Variable interest rates are available for mortgages, cars, credit cards, and more. These types of loans can be based on the prime rate in a specific country, too.

Banks and other lenders charge borrowers a range of possible interest rates based on the loan's benchmark index. This range depends on various market factors like the kinds of assets involved in the loan, the borrower's credit score, and index performance. This combination of factors can make figuring out variable interest rates a bit complex.

What Can They Be Used For?

Many types of loans can have variable interest rates. For example, residential mortgages can have either fixed or variable interest rates. Variable interest rates are also used in corporate bonds, swap contracts, credit cards, and various types of securities. While various factors go into deciding whether a fixed or variable interest loan is best, much of the time, borrowers have the choice between the two. Most lenders do not offer just one type of loan. However, most lenders will only give fixed or variable interest rates under specific circumstances. This inherently limits borrowers' options when applying for financing.

How Do Variable Interest Rate Credit Cards Work?

Variable interest can also be applied to credit card transactions. These credit cards have their own APR (annual percentage rate) that is determined based on a specific index like the prime rate. Since the prime rate usually changes when the Federal Reserve makes adjustments to the federal funds rate, these cards will generally only change their interest rates under that circumstance. Regardless, like other variable interest loans, variable interest credit cards can change their interest rates at any moment without notice to the borrower.

Like other loans, credit cards' terms and conditions are vital for borrowers to understand what they agree to repay. Interest rates are usually listed as the prime rate with an additional percentage. That percentage is usually connected to the credit score of the borrower. For example, you will often see interest rates described as "prime rate plus 5 percent" or something similar.

How Do Variable Interest Mortgages Work?

Variable interest mortgages and other variable-interest loans operate much the same way as variable interest credit cards. The key difference is the repayment schedule. Credit cards are considered a revolving line of credit that can be called on and repaid at any time. Alternatively, variable interest rates are typically used for installment loans. That means that your payments are scheduled ahead of time: after a specific number of payments, your loan will be fully repaid after an expected date. Interest rates vary, so payments change according to how the rate changes and how many payments are left before the loan is fully repaid. 

If a home loan has a variable interest rate, it is usually called an ARM (adjustable-rate mortgage). ARMs usually begin with low-interest rates that are fixed for a set amount of time, often the first few years on the life of the loan. After this period, the rate becomes variable and subject to change at any time. ARMs are typically fixed interest for three or five years, which is conveyed as 3/1 or 5/1, respectively. 

ARMs usually also have rates that change based on a predetermined margin and a major mortgage index. These include indexes like COFI (11th District Cost of Funds Index), MTA (the Monthly Treasury Average Index), or the LIBOR. So if a LIBOR-based ARM has a 2 percent margin and the LIBOR rate is 3 percent when the ARM's rate changes, the rate will reset to 5 percent. This is because the rate is determined by the margin and the index together.

What About Bonds and Securities?

Variable interest bonds can use the LIBOR, while some use five, 10, or 30 year U.S. Treasury bond yields as their benchmark rate. The latter often give a coupon rate set to a certain range above the Treasury's yield. Interest rates can also be variable with fixed-income derivatives. Interest rate swaps are one example. This is when a forward contract with a stream of future interest payments is traded for another one with a predetermined principal. Interest rate swaps often involve exchanging a fixed rate for a variable one or a variable rate for a fixed one. This can reduce the borrower's exposure to market fluctuations and rate changes or allow a better interest rate. Interest rate swaps can also be done with two variable interest rates. This is known as a basis swap.

The Bottom Line

Variable interest loans have fluctuating interest rates over the life of the loans because they are based on benchmark interest rates or indexes that are subject to market adjustments. Benchmark interest rates for variable interest rates are different depending on the type of loan, but they are usually linked to the federal funds rate or the LIBOR. Variable interest loans are used for credit cards, mortgages, bonds, derivatives, securities, and various other types of financing. In some cases, this arrangement gives borrowers the ability to get lower initial interest rates. However, consumers should be cautious and carefully consider whether they can repay loans based on the range of potential interest rates.

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