What is a Variable Interest Rate?

A variable interest rate is an interest rate on a loan that can change at any time and without notice, either up or down. This contrasts with a fixed interest rate which does not change throughout the loan period. For example, you might have your mortgage on a variable interest rate because you have some kind of risk factor associated with your loan that could increase the cost of your mortgage over time, like if you are self-employed or if there is an economic downturn in your area.

Calculating a Variable Interest Rate

To calculate an interest rate that varies over time, simply multiply your future value by your interest rate. If you have $10,000 in savings and your current interest rate is 3 percent, for example, then you’ll have $10,300 in savings one year from now. If you’re borrowing money at a 5 percent interest rate instead of saving money at 3 percent, then you’ll owe $10,500 in one year if you leave that loan as-is. Calculating an average of two or more rates can be done using calculus or by using compound interest equations.

The Difference Between Fixed and Variable Rates

Because you are taking on more risk, a variable interest rate is the financial equivalent of risky talk in communication. Most financial institutions, by way of incentive, will offer higher rates in return. When market conditions shift and the bank raises or lowers their variable interest rates, you’ll be affected as well. Fixed-rate loans come with a fixed interest rate for a fixed amount of time. 

As long as your credit is in good standing and you keep up with your payments on time, you can expect to have the same amount due each month for those three years. The advantage of these types of loans is that if interest rates decrease after you sign your loan agreement, you will be able to take advantage of the better rates. But if interest rates go up during that period, you won’t be in a position to profit from it. The primary drawback with fixed-rate loans is that they typically come with higher monthly payments than variable-rate loans because they have lower initial interest rates. Because the interest rate for their smaller monthly payments isn’t fixed, people may be less attracted to them if borrowing costs decrease.

How Do They Work Together?

Your interest rate, also known as your annual percentage rate (APR), describes how much you’ll pay on your credit card each year. An interest rate that can change over time, like those for variable-rate cards, is known as a variable interest rate. The Federal Reserve, or Fed, plays an important role in determining how variable rates work. Rates are based on market conditions and financial stability. There are two main types of variable rates introductory and standard. Both types have caps that limit how high they can go. For example, if you have a standard variable rate with a cap of 18%, it will never go above 18%. However, it could be lower than 18% at some point during your first year as well. It all depends on what happens to interest rates overall during that period.

Benefits of Variable Rates

If you choose a variable interest rate, the interest rate can change over time. A fixed interest rate, on the other hand, will have the same interest rate and monthly payment throughout the entire loan term. One of the most significant benefits of variable rates is that they can reduce monthly payments when compared to fixed rates. If you anticipate that interest rates will increase during your loan term, you might consider taking out a variable-rate loan so that your mortgage payments remain as low as possible. Keep in mind that when rates go up, so will your mortgage payment.

Disadvantages of Variable Rates

First, consumers should be aware that variable rates come with certain risks. If interest rates fall, for example, your payments could go up. That’s because some variables are tied to indices like prime and LIBOR. As interest rates rise, you may be hit with higher monthly payments. Also consider that unless you have an adjustable-rate mortgage (ARM), your rate won’t increase when market conditions force it up—but it also won’t decrease when market conditions lead to lower rates. If you choose a fixed-rate mortgage over an ARM, make sure to know what steps you can take if/when interest rates fall so you don’t miss out on savings.

Signs and Effects

As with any other loan, an individual can only receive a variable interest rate if they possess an outstanding credit history. If an individual has bad credit, they will not be able to qualify for their desired loan. However, there are still options open to individuals with bad credit, but they will likely have to go through more stringent measures than individuals with good credit. The signs and effects of poor credit also differ from those of good credit; in general, having poor or bad credit limits your ability to borrow money in a short period, but having excellent credit allows you to be approved for loans and get them much faster. As well as getting approved more quickly, higher interest rates can also affect your ability to get cheaper loans.

Facts and Figures

A variable interest rate can refer to several different kinds of loan, credit, or debt payment terms. The term variable refers to an interest rate that will fluctuate along with changes in prevailing market conditions. A variable interest rate loan isn’t tied to any fixed percentage of market interest rates, but rather it is tied to one of two different variables: either an external index, like a stock market index, or some other kind of specified numerical value. Most loans are based on indexes and change their rates at regular intervals; for example, adjustable-rate mortgages (ARMs) often adjust monthly, while shorter-term loans may vary every quarter or even daily. Some other examples of variable loans include lines of credit and home equity lines of credit (HELOCs).

Example

Let’s use an example to illustrate what a variable interest rate is and how it works. Let’s say you have $10,000 that you’d like to deposit into a savings account paying 3% annual interest. At first glance, it seems simple enough: You deposit $10,000, and you earn $300 in annual interest (3% of your initial deposit). 

However, because many banks offer variable rates of interest on their accounts—instead of fixed rates—things aren’t quite as straightforward as they seem. What if you want to increase your rate of return by 1%? What then? Well, that would mean increasing your deposit by 1%, too. So instead of depositing $10,000, you would need to deposit $10,100 ($10K x 1%). And if you wanted to bump up your earnings by 2%, you would need to deposit another $100 for a total of $11K ($10K +$1K =$11K). In short: When earning interest at a variable rate, any change in interest is reflected proportionally in changes in deposits.