What Is a Variable Interest Rate?
A variable interest rate, also called an “adjustable” or “floating” rate, is a 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 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. Fixed interest rates, on the other hand, do not fluctuate.
Key Takeaways
- A variable interest rate changes over time based on an underlying benchmark interest rate or index.
- The underlying benchmark can vary depending on the loan or security, commonly linked to the LIBOR or the federal funds rate.
- These rates can be found in mortgages, credit cards, corporate bonds, and derivatives.
Understanding Variable Interest Rates
Variable interest rates rise and fall with the market or a specific index. Depending on the type of loan or security, the benchmark for these rates is often associated with either the London Inter-Bank Offered Rate (LIBOR) or the federal funds rate.
For mortgages, auto loans, and credit cards, the rate may be based on a prime rate. Financial institutions typically charge a spread over this benchmark rate, influenced by factors like asset type and the consumer’s credit rating. Therefore, a variable rate may be stated as, for instance, “LIBOR plus 200 basis points” or “LIBOR plus 2%.”
Residential mortgages can come with fixed or adjustable interest rates, with the latter adjusting periodically based on market conditions. Variable rates are also common in credit cards, corporate bonds, and swap contracts.
Due to issues surrounding its reliability, LIBOR is being gradually phased out and replaced by the Secured Overnight Financing Rate (SOFR) by June 30, 2023.
The Intricacies of Variable-Interest-Rate Credit Cards
Variable-interest-rate credit cards tie their annual percentage rate (APR) to an index like the prime rate. Changes in the prime rate, often prompted by adjustments in the federal funds rate, affect the credit card rate. These rate changes can occur without notifying the cardholder.
In the terms and conditions of credit cards, the interest rate is typically the prime rate plus a certain percentage, reflecting the cardholder’s creditworthiness, e.g., prime rate plus 11.9%.
Variable-Interest-Rate Loans and Mortgages Explained
Variable-interest-rate loans operate similarly to credit cards but follow a set payment schedule. Most loans are installment-based, meaning they have a specific number of payments to be made by a particular date. As interest rates change, monthly payments can increase or decrease.
An adjustable-rate mortgage (ARM) typically starts with a low fixed rate for a few years, referred to as 3/1, 5/1, or 7/1 ARMs for three, five, or seven-year periods, respectively. Subsequent adjustments depend on indices like LIBOR, COFI, or MTA. Furthermore, ARMs often have caps on rate adjustments to limit changes.
Understanding Variable-Interest-Rate Bonds and Securities
For variable-interest-rate bonds, the benchmark might be the LIBOR or yields on U.S. Treasuries. Fixed-income derivatives, like interest rate swaps, can also have variable rates. In an interest rate swap, streams of future interest payments are exchanged, usually to switch from fixed to floating rates for benefits such as reducing exposure to rate fluctuations or achieving lower rates.
Pros and Cons of Variable Interest Rates
Pros:
- Typically lower than fixed interest rates.
- Benefit for borrowers when rates decline.
- Benefit for lenders when rates rise.
Cons:
- Rates could rise to burdensome levels for borrowers.
- Creates challenges for budgeting due to unpredictability.
- Makes it harder for lenders to forecast future cash flows.
Related Terms: fixed interest rate, LIBOR, SOFR, prime rate, interest rate swaps.
References
- Corporate Finance Institute. “Floating Interest Rate: What Is a Floating Interest Rate?”
- Corporate Finance Institute. “Floating Interest Rate: Use of Floating Interest Rate”.
- Corporate Finance Institute. “Floating Interest Rate: Uses of Floating Interest Rate”.
- The Intercontinental Exchange. “LIBOR”.
- Debt.org. “How is Credit Card Interest Calculated?: Variable Interest Rates”.
- Freddie Mac. “How it Works: Adjustable Rate Mortgages (ARMs)”.
- U.S. Securities and Exchange Commission. “Floating-rate Bond (or Variable or Adjustable rate Bond)”.
- Corporate Finance Institute. “Interest Rate Swap”.
