A variable-rate loan is financing with an interest rate that fluctuates over time. It contrasts to a fixed-rate loan with a steady interest percentage. Variable rates are available on most types of secured and unsecured loans. Relative to fixed loans, variable-rate loans typically offer lower upfront payments, but interest can spike much higher than the fixed rate over time.
With a variable-rate loan, your interest rate is adjusted periodically to align with changes in the London Interbank Offer Rate, federal fund rates or other prime interest rates. When government loan rates are low, your interest is low as well. When federal rates increase, your rate does as well. The bank usually charges a percentage markup on top of what it pays for the money it borrows to service loans.
Variable-Rate Loan Benefits
The initial period of low interest is a major advantage of a variable-rate loan. Because of the lower upfront rate, you can potentially buy a more expensive home, car or boat with a secured loan. Other benefits of variable-rate loans relative to fixed-rate loans include:
Refinance savings -When interest rates fall, you benefit from the lower interest charges without having to refinance your loan as someone stuck in a high-rate fixed loan would.
Quick transitions - Bankrate pointed out that low variable rates are a great structure for someone looking to own a property for a brief time. Investors who flip homes, for instance, often use variable-rate loans because they sell the house before rates jump.
Variable-Rate Loan Drawbacks
The major risk of variable-rate loans is a dramatic spike in your interest charges when lending rates go up. Longer loan terms increase the likelihood that your interest rates and payments go up over time, according to the Consumer Financial Protection Bureau. Bankrate also noted that it isn't unheard of for the interest on adjustable-rate mortgages to jump several percentage points within a few years.
Other compelling drawbacks of variable-rate loans relative to fixed-rate loans include:
Budgeting uncertainty - With a fixed-rate loan, you have consistent monthly payments over the entire repayment period. With a variable-rate loan, your payments can climb quickly at the first rate adjustment. The ups and downs of interest rates and payments makes it hard to know how much to set aside for debts.
Complexity - Variable-rate loans are much more complex than the straightforward fixed loan. Less scrupulous lenders play around with loan contracts and intentionally confuse borrowers with language about such things as rate adjustments, margins and caps, according to Bankrate.