Variable-rate loan

What is a variable-rate loan?

A variable-rate loan is one where the interest rate on the loan balance changes as rates in the market change, based on an index. As the interest rate changes, so does the monthly payment. Types of variable-rate loans include adjustable-rate mortgages, home equity lines of credit (HELOC), and some personal and student loans.

Deeper definition

Variable-rate loans are different from fixed-rate loans. The interest rate doesn’t change on fixed-rate loans, but it can become higher or lower on variable-rate loans. Interest provides the incentive for banks to lend money, so banks want to charge the highest interest rates they can.

As the interest rates on financial index change the lender may adjust the interest rate to follow the respective financial index. Some of the most common index used are the key index rate set by the Federal Reserve or the London Interbank Offered Rate (Libor). The lender will only update the interest rate periodically, with a frequency agreed to by the borrower, which means that a change to the index interest rate doesn’t necessarily translate to immediate changes to the loan’s interest rate.

Borrowers will likely have a lower rate at the beginning of the loan, but the rate may increase over time. A variable-rate loan may be worth the inherent risks because it may save borrowers money on interest. From the lender’s perspective a variable-rate loan is far less risky than a fixed-rate loan, which could stick the bank with a low interest rate even if market rates are much higher.

The interest rate on a variable-rate loan is calculated by taking the interest rate of the index it’s tied to and adding a few percentage points, which the lender will spell out in the loan agreement. However, some variable-rate loans have a cap so that the borrower will never be charged over a certain interest rate regardless of the index interest rate.

Check out Bankrate’s personal-loan comparison tool to see what variable-rate loans are out there.

Variable rate loan example

Trey asks his bank for a personal loan to cover some expenses. The bank tells him he has two options: a fixed-rate loan or a variable-rate loan. The fixed-rate loan is 4 percent, and the variable-rate loan is the index rate plus 1.5 percent. Trey believes the index rate will be lower for a while, so he therefore finds the variable-rate loan to be better for his interest payments. According to the loan agreement, Trey’s bank will reassess and adjust the interest rate every six months. For the first six months, the index rate is 1.5 percent, so Trey only pays 3 percent interest. After six months, the index rate has gone up to 1.7 percent, so now Trey pays 3.2 percent.

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