What is a variable interest rate?

The interest rate on a loan or instrument that varies over time is known as a variable interest rate (sometimes known as an “adjustable” or “floating” rate). This is because the rate depends on an underlying benchmark interest rate or index subject to periodic adjustments.

A variable interest rate has the apparent benefit of allowing the borrower’s interest payments to decrease with a lower index or underlying interest rate. In contrast, interest payments climb if the underlying index increases. Fixed interest rates are constant, in contrast to fluctuating interest rates.

Knowing About Adjustable Interest Rates

An interest rate that fluctuates in tandem with the market or an index is known as a variable interest rate. Depending on the kind of loan or instrument, the underlying benchmark interest rate or index for a variable interest rate is commonly linked to the federal funds rate or the London Inter-Bank Offered Rate (LIBOR).

Credit card, vehicle, and mortgage variable interest rates might be based on a benchmark rate, such as the prime rate of a nation. Banks and other financial institutions charge customers a premium above this benchmark rate; the premium varies based on several criteria, including the asset type and the customer’s credit score. A variable rate might thus advertise itself as “the LIBOR plus 200 basis points” (plus 2%).

For example, fixed interest rates on residential mortgages are unchangeable during the term of the mortgage agreement; floating or adjustable interest rates, on the other hand, are subject to periodic adjustments in the market. Credit cards, corporate bond issuance, swap contracts, and other instruments may also have variable interest rates.

LIBOR is being phased out because of recent scandals and doubts about its suitability as a benchmark rate. According to the Federal Reserve and U.K. authorities, the Secured Overnight Financing Rate (SOFR) will take on the role of LIBOR by June 30, 2023. After December 31, 2021, LIBOR’s one-week and two-month USD LIBOR rates will no longer be released as part of this phase-out.

Credit Cards with Adjustable Interest Rates

Credit cards with variable interest rates feature an annual percentage rate (APR) linked to a particular index, such as the prime rate. Most often, changes in the federal funds rate by the Federal Reserve impact the prime rate and, therefore, the credit card rate that is linked with it. Credit cards with variable interest rates are subject to rate changes without providing prior warning to the customer.

Credit cards with variable interest rates can alter rates without informing their users.

The interest rate is often stated as the prime rate plus a certain percentage in the credit card’s “terms and conditions” agreement. The indicated percentage is dependent on the cardholder’s creditworthiness. 11.9% plus the prime rate is an example of the format.

Mortgages and Loans with Adjustable Interest Rates

Loans with variable interest rates operate like credit cards, except for the repayment period. A credit card is classified as a revolving line of credit. However, most loans are installments that must be repaid by a specific date after a predetermined number of installments. The necessary payment will fluctuate based on changes in interest rates and the total number of installments needed to complete the loan.

An adjustable-rate mortgage (ARM) is the more popular term for a mortgage with a variable interest rate. For the first few years of the loan, many ARMs have a low fixed interest rate that only changes after that time has passed. Three, five, or seven years are typical fixed-interest-rate durations on an ARM; they are represented as a 3/1, 5/1, or 7/1 ARM, respectively. Additionally, adjustment “caps” often set a maximum amount that may be adjusted when the interest rate changes.

Rates for adjustable mortgages (ARMs) often fluctuate in response to a primary mortgage index, such as the Monthly Treasury Average Index (MTA Index), the 11th District Cost of Funds Index (COFI), or LIBOR, as well as a predetermined margin. For instance, when an ARM with a 2% margin based on the LIBOR is taken out, the rate resets to 5% (the margin plus the index) when the LIBOR is at 3%.

Variable-Interest Securities and Bonds

The LIBOR might be the benchmark rate for bonds with variable interest rates.

A coupon rate set at a specific spread over the yield on U.S. Treasury bonds is provided by some variable-rate bonds, which also utilize the yield on five–, ten–, or 30-year U.S. Treasury bonds as their benchmark interest rate.

Variable rates are also an option for fixed-income derivatives. For instance, an interest rate swap is a forward contract whereby a specific principal amount is used to exchange one stream of future interest payments for another. To decrease or enhance exposure to interest rate swings or to receive a somewhat lower interest rate than would have been achievable without the swap, interest rate swaps often include exchanging a fixed interest rate for a floating one or vice versa.

A basis swap, another term for a swap, is exchanging one variable rate for another.

Benefits and Drawbacks of Adjustable Interest Rates

Pros:

• Compared to fixed interest rates, variable interest rates are often lower.
• The borrower stands to gain from a decrease in interest rates.
• The lender stands to gain from an increase in interest rates.

Cons:

• Variable interest rates have the potential to rise to a point where the borrower finds it impossible to repay the debt.
• It is more difficult for a borrower to budget when interest rates are changeable.
• Furthermore, it makes it more difficult for lenders to forecast future cash flows.

Conclusion

• Because a variable interest rate depends on an underlying benchmark interest rate or index frequently adjusted by the market, it will vary over time.
• Depending on the kind of loan or instrument, the underlying benchmark interest rate or index for a variable interest rate may be tied to the federal funds rate or LIBOR.
• Mortgages, credit cards, corporate bonds, derivatives, and other securities and loans have variable interest rates.